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Merger and acquisition activity continues to be robust as the U.S. economic recovery enters its eighth year. With the continuation of strong valuations, anticipated favorable changes to tax policies, and the prospect of rising interest rates, now is an ideal time for private company owners to focus on factors that will improve their business value in the event of an opportunity to sell.
Ideally, business owners and their management teams should begin monitoring the value of their business at least five to seven years before considering an exit. Monitoring value is something that should be done in any economic environment but the urgency to do so is greater when an economic upswing is several years old.
While valuation appears to be a quantitative science about financial statements, forecasts, multiples, and rates of return, it is actually more qualitative in nature. Valuation is a prophesy of future expectations for a business. To accurately reflect those expectations, it is critically important for a business owner to identify and understand the value drivers, which are factors that increase cash flows and reduce risk associated with business. There are hundreds of value drivers attributable to a business, some of which are industry-specific. For brevity, we will discuss ten of the most universal factors we consider essential to increasing cash flows and reducing risk, thereby enhancing overall company value.
1. Capital Access.
The smaller the company, the more limited its access to debt and equity capital. The company will need to assess the kind of capital needed to achieve its goals.
Questions to ask: How is the company currently leveraged? How do bank covenant restrictions impact the business and its future plans? Do shareholders have to provide equity or personally guarantee loans? Is bringing in an outside investor and issuing preferred stock a viable option?
2. Customer Base.
A solid and diversified customer base is essential for the ongoing viability of a business. When companies grow and prosper by catering only to their largest customers, dependency may increase to the point where too great a percentage of revenues are concentrated with too few customers; companies must manage the allocation of customer concentration to reduce the risk of losing a large source of revenues.
Questions to ask: What percentage do the top five customers contribute to the company’s revenues? What amount of revenue is recurring? What is the economic useful life of its entire customer base, as well as its largest customers?
3. Economies of Scale.
As production output increases, businesses typically achieve lower costs per unit. Whether through quantity discounts or spreading capacity costs over higher volumes, larger companies possess distinct advantages in certain operations and markets.
Questions to ask: Is the company effectively exploiting its internal economies of scale (i.e., cost savings that accrue regardless of the economic environment or industry in which it operates)? What are the company’s growth opportunities to realize additional or larger economies of scale? Can the company enter into a consortium, joint venture, or outsource to increase buying power and reduce expenses?
4. Financial Performance.
Financial analysis aids in measuring trends, identifying the assets and liabilities of a company, and comparing the financial performance and condition of the company to other, similarly-positioned firms. Internally prepared and compiled financial statements may hamper management’s assessment of performance, causing potential buyers to possibly question the quality of this data.
Questions to ask: How does the company compare in terms of liquidity, activity, profitability, and solvency measures? What financial controls are in place? Are the financials audited or reviewed by an outside CPA?
5. Human Capital.
A company’s employees are the heart of an organization. Key value drivers include the knowledge, skills, experience, training, and creative abilities employees bring to a business and the health of its company culture.
Questions to ask: What are the quality control procedures? How effective are the production/service capabilities? How is the company managed? What is the depth and breadth of management? Are there any key person dependencies in terms of technical knowledge, production skills, or customer contacts? Is there a management succession plan? What rights do individual shareholders have?
6. Market Environment.
Each business is impacted by economic trends and developments in the industry in which it operates. Management must understand how the industry is impacted by economic factors and how the industry is structured to minimize the impact of macro trends on the business.
Questions to ask: What is the company’s market share? Where is it positioned in the market? Does management have an understanding of its niche and unique offering? Does it have diverse offerings that can modulate the impact of economic swings?
7. Marketing Strategy and Branding.
Marketing is the link between customers’ needs and their response to a company’s products/services. Strong branding will not only improve company sales by increased market recognition, it will also provide a clear direction that will improve operational efficiency when tied to the company’s mission.
Questions to ask: How does the company market itself? What are its marketing and sales capabilities and shortcomings? How effective and known is its brand? What is its social media presence? How effective is its website? Is the brand tied to the company’s mission statement and its strategic direction?
8. Product/Service Offering.
Specialty companies frequently derive their strength from focusing in niche fields, but concentration may create risks from lack of diversification and overdependence on limited markets. Some specialty companies may find their largest customers adopt a policy to deal only with suppliers who offer a broad range of products, forcing them to either expand product offerings or sell out to a larger company. Increasing the diversification reduces risk, which improves value.
Questions to ask: What is the company’s mix of offerings? Are any concentrated offerings subject to economic and industry swings? What products/services can be offered that differ from existing ones but use similar human capital, production capability, customer base, etc. to diversify? What opportunities exist for vertical or horizontal integration?
9. Strategic Vision.
Most companies put together a one-year budget, but few attempt to put together a business plan or long-term forecast. Valuation is all about future expectations and company management needs a strategic vision to create value. Management must take a look at all the information they’ve gathered from reviewing their company to divulge a strategic vision that can be passed along to the future owner, providing additional support and assurance of continuity, and even increase, of sales.
Questions to ask: What is management’s long-term outlook? When did the company last write a formal business plan? Is the company’s strategy in tune with its customers’ demographics, tenure, needs, and demands?
Companies with fewer monetary resources often lack adequate research and development resources, finding it difficult to keep pace with technological changes in their markets. Such companies often face an inescapable need to incur large amounts of capital expenditures in the near future or allocate resources to a limited number of product development projects. This inevitably results in product or service obsolescence, adverse impact on future growth, and loss in market share. In the meantime, larger companies are in a better position to demonstrate technological expertise by developing products that address emerging customer needs, leading customers to choose the state-of-the-art products, despite the eventual availability of lower cost, lower performance technology.
Questions to ask: How many resources does the company allocate to R&D? Is their use of technology up-to-date? Are there impending technological changes that could negatively impact the company’s product/service offering?
Ongoing assessment of a company’s value drivers is integral to its success. The valuation process involves both a quantitative and a qualitative assessment of a company that should be part of any business owner’s standard operating procedure as a useful and important business management exercise. A valuation assessment can provide the business owner with meaningful and oftentimes actionable information that highlights the real intrinsic value of the firm and ultimately maximize returns.