Like any good question, there is more than one answer to this question. In fact, there are two.
The first answer concerns the business itself, while the second answer concerns the sales process. It is during the sales process that the how, when, and why of selling are examined. In this article, I will address the business issues focusing on the factors that you, as a business owner, can influence in your existing business to improve value. This isn’t about inventing a new mouse trap, but rather to give you an overview of basic steps you can take.
Last year, I wrote an article on the basic math of valuations that presented the risk return curve. A company will attract a higher multiple if it moves to the left on the risk return curve. This means that a higher multiple is paid for lower risk. However, the biggest driver in attaining a higher multiple is a company’s profitable growth prospects, which can and should already be evidenced by a historical profitable growth trend.
How the "Growth" Math Works
Let’s look at the public markets for an illustration. The dividend discount model asserts that the fair value of a stock is the present value of all future dividends. I’m going to get into some math, so bear with me.
The formula is as follows: fair value of a stock = DPS(1) / Ks-g, where the expected future dividend stream is divided by the required rate of return (Ks) minus the expected growth rate (g). If a dividend is $5.00, and the required rate of return is 20%, then the fair value of the share price is $25.00 ($5.00/0.2) according to this model. If the expected growth rate is 10% then the fair value jumps to $50.00 ($5.00/0.1). The growth rate lowers the required rate of return and increases the fair value of a stock. In this case, 10% per annum growth translates into a 100% price improvement. That is a tremendous amount. The real world experience is not as exact, but the illustration demonstrates the logic and impact of growth prospects on company value.
The same logic applies to EBITDA growth for private companies. Returning to the example provided in my previous article, a company sustainably generating $5 million in EBITDA is valued at $20 million, four times EBITDA, the equivalent to generating a 25% return on capital per annum. if this company were growing at 20% per annum, the multiple could quite readily improve to 6 or 7 resulting in a valuation of $30 to $35 million. Again, not quite as exact as the formula but the results are still very substantial.
What About Risk?
While growth is important, a business owner should not chase it at all costs. There are a number of ways that risk can be managed; below I provide three areas where business owners should focus well before selling a company.
Is the owner redundant?
The first thing to address when considering a company sale is to put a strong management team in place that can run the business without the owner. An owner operator who is the chief product developer, or maintains all of the customer relationships, will not be able to exit the business upon its sale. He/she will have to commit to staying with the business until a suitable replacement solution is implemented.
Is the customer base diversified?
The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a smaller company, but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration. While the growth that it drives will increase value, the associated risk of these revenues will reduce value.
Are the revenues recurring or project based?
Does every fiscal year start at zero? What I mean by that is, if your revenues are project based then you are always searching for the next deal. Consulting companies typically face this challenge. Along the same lines, a one product company is more risky than a diversified product and services company.
Strike the Right Balance Between Growth and Risk
The above risk factors are but three examples of situations where reducing the risk will increase the multiple. This concept applies in general: any combination of improving profitable growth prospects and reducing risk will increase the value of your company, so strike to strike the right balance. As I mentioned previously, these are business factors that drive the multiple higher. However, managing the sales process can be just as important to attract a high multiple.