It shouldn’t be any surprise that buyers of privately-held companies are focused on profit margins and EBITDA. These aren’t the only drivers of valuation, however. Here’s a look at five variables that play strong roles in how investors value smaller companies because of their impact on the future potential of the business.
1) Management Team
Having a strong management team with a definitive plan for business growth drives a premium valuation. One of the biggest hurdles to selling a business is the transition of management. If you drive much of the business and want to leave soon after close, you will likely see the offer and transaction structure reflect the buyer’s desire to protect the downside risk of your departure. The buyer can be more assured of future opportunity within the company when a team is in place and able to provide a large amount of upfront information to chart the company’s course, resulting in a stronger offer.
Not every seller has a well-rounded management team or the ability to recruit the talent it requires. In fact, most small business owners tend to run lean organizations, which can create gaps in management as the company grows. It’s important to be realistic about the role you play in your organization and your management needs, since those will affect the buyer’s investment calculation. Some business owners may have an opportunity to recapitalize their business (rather than sell it outright) and work in partnership with a private equity firm to enlarge their team and implement their growth plan. This is a terrific option for owners that still enjoy what they do, but may want to partner with a team that has the resources to take the company to the next level or to simply take some chips off the table. The recapitalization structure may allow for a much smoother transition and ultimately deliver more value to the seller over time.
2) Industry Trends
The industry trends that impact your business will also impact your valuation. If you hear of a friend that sold his business for two times revenue, don’t ignore the fact that the business may have been a unique technology company growing at 300 percent annually. When considering your own company, assess the overall industry, the niche you are in, current trends and opportunities for growth. Specifically, a potential buyer will be interested to know whether you are growing faster or slower than the market, what the projected growth of the market is, your position within the market (leader or follower?), and how quickly your company is increasing market share.
Consider whether your growth is sustainable. Is your company rising with the tide or growing because of a sustainable strategic plan that will help boost value over time? Was the recent great year a one-time event or the beginning of a trend? There are some industries that have obvious growth potential, such as healthcare and IT. If, however, you are in another industry, be prepared to articulate industry and company-specific projections. Evidence of strong financial and industry projections provides the buyer with the confidence that an investment in your company is going to pay off.
Concentration metrics also influence valuation, since high concentration issues can signal risk. Customer and supplier concentrations are obvious issues buyers will want to understand. When high concentration issues exist, you will need to be able to explain what gives you confidence in your customer and supplier relationships, or expect that there may be hurdles to getting a buyer comfortable with those dynamics. Additionally, two other related concentration issues worth understanding:
First, does one person manage all or most of the company’s customer relationships or supplier relationships? If that person is committed to remaining with the company, a high relationship concentration may not be a big near-term concern. You will benefit, though, if there is a plan to transition or share leadership of these important relationships with other team members.
Second, does the company have a large share of customers in a single sector (e.g., home-building), and is that sector susceptible to market cycle swings? Even if a company serves a diverse customer base within one industry segment, a cyclical sector will be valued differently than a growing sector. Therefore, it is a good exercise to understand how cyclical your market segment is and as well as how the company is performing in the current cycle.
4) Additional Capacity
Is your business’ growth potential limited by current operational constraints? For example, you may be able to double your sales, but if you are running two shifts at capacity and have no ability to add to your facility, you are limited to your current volume. Your company may still present a tremendous investment opportunity. There are plenty of buyers eager to support growth in strong companies, however, expect the buyer to factor into your valuation the additional investment required to achieve the growth.
Understand where your company is nearly “maxed out” – is it the building, your equipment, or people? If you operating at 95 percent of capacity, moving to a different building or adding onto the existing one both require significant investment. If you run an equipment- intensive business, what is the condition and functionality of the equipment? Be prepared to discuss the history and patterns of your capital investments in order to project future equipment needs. Lastly, look at your organizational chart. If a new owner needs to invest in labor to achieve the future growth projections, expect that added cost structure to affect your valuation.
5) HR Concerns
Buyer scrutiny of HR issues is relatively new and prompted by changes in the regulatory environment, driven primarily by the federal government. Taking some time to ensure that the seller has an understanding of how these issues may affect the business, and working with a specialist as needed, can go a long way in heading off buyer concerns. Toward that end, be able to discuss hot-button topics that can add layers of cost, like:
Health Insurance. Does the company currently provide health insurance? To what extent has the Patient Protection and Affordable Care Act (ObamaCare) affected, or will it affect, the company? Has the company recently had an insurance renewal date and does its business forecast account for any new costs?
Employee Documentation. Employee documentation rules have become increasingly rigid. With all of the talk in Washington about immigration reform, the scrutiny around I-9 employment eligibility forms is more intense than ever. Have you established good processes for maintaining employment records and for completing required government documentation?
Minimum Wage Impact. Many states are working to increase the minimum wage. If you employ minimum wage workers, to what extent will rising wages affect your business operations?