Helping business owners understand what drives an enterprise valuation and what specific actions should be taken in order to enhance that value are two of the most important duties of a mergers and acquisitions advisor.
Working toward a maximum valuation is a best practice within any business. Knowing what parameters drive value, what buyers want to see and the steps that increase business valuations should be important to every single business owner. It’s crucial for those looking to sell soon or in the future as well as those who plan to keep the business for the long run.
While private company business valuations rely on a multitude of factors, it is never too soon to begin managing your business with valuation in mind.
Understanding the Very Basics of Business Valuations
Not surprisingly, value means different things to different buyers. The perceived value depends on the circumstances, interpretations and the role that is played in a transaction.
The most important part of the company valuation involves determining the amount of cash flow the business can generate in the future.This serves as an important input to set the overall enterprise value. It also sets the stage for some of the most important considerations buyers look at in determining if the business will make a good investment. These considerations include metrics such as return on assets, return on equity, return on investment and a host of others that track the performance of the money invested into the business.
Since this determination involves speculation about what the future holds, there is always some uncertainty involved.This uncertainty regarding future performance creates risk; therefore, we have to include a “risk premium” or “risk factor” which will discount value.
For companies with positive cash flow, a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) is a very common measure of value. For companies that have negative cash flows, you would likely see valuation based on a percent of the market value of the assets, less liabilities. This is called the liquidation value of the business.
These financial parameters will set the baseline for the initial determination of value.
Potential buyers usually place different parameters on how they determine the valuation of a business. Some hold a lot of weight in terms of how a typical buyer would assess value to a given company. These parameters serve to adjust their valuation and rarely do they result in an increase in their valuation. Understanding these parameters will help you manage your business for a maximum valuation, ultimately getting the best value when it comes time to sell.
Ranked from most important to least important, these parameters show what drives and influences business valuations. Of course, these are not all the factors and every individual business valuation is different from the next. This ranked list should serve as a general guide to show the parameters that tend to be the most important to buyers.
Primary Drivers of Valuation:
- Size of Revenue
- Historical & Projected EBITDA
- Revenue Stability
- Margin Percentages
- Return on Assets
- Growth Potential
- Location / Target Markets
- Customer Concentrations
Secondary Drivers of Valuation:
- Financial Controls
- Asset Quality
- Revenue Concentration
- Competitive Landscape
- Asset Turns
- Staff Deficiencies
- Material & Equipment Demands
- Quality Control
- Regulatory Issues
Other Potential Drivers of Valuations:
- People Turnover
- Local Talent Pool
- Operations Systems
- Payroll % of Sales
- Legal Issues
- Certifications & Licenses
As outlined above, managing a business to drive valuation and the success of the business go hand-in-hand. For those looking to sell a business in the shorter term, emphasis should be geared toward overall financial improvement, as those are the most important metrics that drive value.
Valuation is in the Eye of the Buyer
There are bound to be differences in how important these factors are to strategic versus financial buyers. One such difference can be found in the makeup of the customer base. Financial buyers want to know that customers will stay around for a long time, whereas strategic buyers are often looking to gain access to a specific set of customers they have yet to penetrate.
The key takeaway from the valuation list is that business owners need to work everyday to build a strong case for revenue surety. This can only be done with discipline and focus on measuring and improving key drivers of the business. The stronger the business can defend future earnings potential, the stronger the case for a high valuation.
Buyers will always look for deficiencies that may be difficult for the business to overcome. Is the business stable enough to support the work needed to hit the revenue and financial projections? How important is the management team to this task and are they all on board after the transaction? Is the future regulatory environment a giant risk to the business? Hundreds of questions like these will need to be considered and addressed in an intelligent manner in order to justify a strong valuation. Although some of these items may not be deal breakers to buyers, they will certainly be used to bring down the valuation in a negotiation.
Be the Driver of Value
So how do you get better at these valuation parameters? One best practice is to conduct regular internal due diligence events on your own business. Go through some of the basic items on the list above and see how your company compares to other companies in your industry.
Business valuations are extremely complex and time-consuming, with many possible outcomes. For the best results, contract a professional who is certified to provide an expert opinion on the range of value for your business.