This is for you if you have ever thought that you would like to sell your business one day.
Most people know that the usual way to value a business is to apply a multiplier of three times the net profit and that’s fine as a rule of thumb but there is a much higher level of sophistication than that which you might like to know about.
Building Value Into Your Business is Easier Than You Thought
There are 8 factors affecting the value of a business (or for that matter detracting from the value) that should be taken into account.
Factor #1 – Financial Performance
When assessing the financial performance, what’s the top line revenue? What’s the bottom line net profit number? Are all those numbers defendable? Will these numbers withstand close scrutiny? In relation to net profit, I always say to my clients – if the net profit range is in the zero to 5% net profit band, well then, that is a business that is on life support. If you think you can breathe life into, it may be worth paying next to nothing for it so that you get the chance to do what the owners couldn’t and turn it around to put it into profit. If the range is 5% to 10% net profit, well then the business isn’t great but its heading towards being good. The good range is a return of 10% net profit. 10% net profit is the new breakeven SO LONG AS the owner has been paying themselves properly and still delivering a 10% net profit return. If the business is in the 10% to 15% net profit space, then it is starting to get into the great zone and a net profit return of 15% + is verging on being excellent – but a business like this will likely be attracting a lot of competitive attention as others try to copy the winning formula…
Factor #2 – Growth Potential
If you’re selling your businesses, you’ll be proud of what has happened to this point. But that’s what happened in the past. You need to understand that what the buyer is buying is what will happen in the future; what do they assess as the future return on this potential investment? They will be considering what will be the future stream of profits that the business can generate. Can the business be scaled up? Can it move into a different market or an allied market? Can it be operated in a way that would get a better return on sales and any marketing spend?
Factor #3 – Over Reliance
The third way of valuing a business is to do with understanding its level of reliance on 3 areas in particular. I mean is the business overly dependent on any one thing or group? Area #1 – is it overly reliant on particular employees? If any of those left, would it be the case that the business wouldn’t be as strong? Area #2 – is it overly reliant on any particular customer or customer groups? And area #3 – is the business over reliant on particular suppliers? Are there any suppliers who might be able to hold a gun to the head of the business and affect its pricing? If there is good diversification on those three fronts, the business value to a purchaser will increase.
Factor #4 – Financial Performance – Cash Flow Strength
The fourth area is to do with its cash flow strength. Is it a cash cow business? How easily can it be milked to yield a good flow of cash? A business is a cash generating engine – or at least it should be. How does cash flow through business? Because if you’re buying a business you need to be able to fund the purchase price of the business AND you’re also going to have to fund the needs of the business for stock, for general cash flow, for it’s working capital. So is the business strong in terms of generating cash and is it trending a strong cash flow?
Factor #5 – Recurring Revenue Stream
What is the incidence of recurring revenue? There are different types of recurring revenue streams and they have varying values attached to them. Running from the lowest value to a purchaser, up to the highest, they are as follows.
Repeat purchasing – consumables. If a business is one where people are regularly buying a consumable like say coffee, or something of that nature, then that might be an attractive business to buy. It’s a business based on repeated daily habits that isn’t subject to seasonality (as would be the case if you sold Xmas tree ornaments) or an inordinate amount of faddishness. With a business that is tapping into nurturing the habits of the customer base, there is a value in the repeat purchasing patterns. And thus its a more attractive business model than a business that’s always having to find new clients.
The next level of recurring revenue in terms of value to a purchaser is sunk money consumables. If you have a Nespresso coffee machine, you have to buy the pods or capsules that fit it or the machine goes to waste.
The next level is subscription revenues. If you are subscribing to a magazine or Netflix or something like that, then chances are the client will continue to buy again and again because inertia sets in, and we don’t change these buying patterns easily.
The next level above this is sunk money subscriptions. If you bought a platform like The Bloomberg terminal hardware, then you’re more likely to buy the software that will work on that.
The next level is the auto renewal space. Something like Iron Mountain document storage where they bill you automatically month by month. Until you tell them to stop, they will continue to store your documents.
And the top level, is contract revenue. If the contract is set in such a way that the customer is obligated to buy from you for a certain period of time, this will be of strong value to a purchaser. So, what is a portion of recurring revenue that exists in the business? How will it impact on the valuation of the business in the eyes of the buyer?
Factor #6 – Monopoly of Control
Does the business have control over its prices or is there a high level of price sensitivity? Is there a deep and wide moat around business? Is there a differentiation – a difference that makes the difference? And is this a difference that is valued by the customers? Does the fact that you use only recycled paper in your packaging cause your customers to buy from you versus your competition? Are you a ‘me to’ business? In other words, do you sell batteries which are exactly the same as can be bought from Coles or Woolies or IGA etc etc. Or do you sell wind up batteries and is that a point of difference that the customers care about? If it is, then it will be boosting the value of your business model.
Factor #7 – Customer Satisfaction Levels
How satisfied are your customers? How likely are they to continue to buy from your company? What is the net promoter score? How likely are they to promote your business to others? How many raving fans do you have? What do you have in place that measures the level of satisfaction of your customers? Have you got data from customer satisfaction surveys that substantiates your claim that the customers are satisfied? What is the level of referrals or word of mouth new leads? The higher the level of incoming leads into business, the more this will boost the willingness of someone to purchase a business for a good price.
Factor #8 – Hub and Spoke
And the final factor is hub and spoke. How reliant is the business on the owner or the founder and on any key personnel in the business? How dependent is the business on the founder being present. If it is very dependent on the founder, then the value will be lower. Also, how systemized is the business? How much of how the business runs is in the minds of the key personnel, particularly the founder or the business owner? How much of the way the business runs has been reduced to systems? How well can the business run if the founder is away sick or on holiday? Will the business struggle without the owner having his finger on the pulse?
So, there you have it. These are the eight different drivers to consider when valuing a business. And if you flip it on its head, they need to be worked on when you are looking to sell your own business. Surely you can see that it would make sense to look at strengthening as many of these as you can and above all else, reduce the reliance of the business on you – the business owner, the founder. And that means having a general manager or a CEO in place AND having a management team in place, because they need to know how to operate all these drivers for you.
And remember the definition of a business is a commercial profitable enterprise that works… without you.
