Value Drivers in Business Valuation
What are the factors that determine what a business is worth? These value drivers for closely held companies do either one or both of the following:
- Reduce risk
- Increase growth/returns
Buyers will compare a potential acquisition target’s risk and return to other available investment vehicles.
Value drivers include:
- A diverse, capable management team
- Sustainable projected cash flows
- A customer base and product/service lines with limited concentrations
- Facility appearance and location
A diverse, capable management team
One of the most important value drivers in any business is its management team. This team is made up of qualified managers with the ability to keep its employees’ interest and engagement in the company at a high level. A potential investor considers an investment in a company with leadership that brings a variety of skill sets to the table more favorable than a “one-person show.”
Additionally, an investor wants to know that the company’s management team will stick around after the sale. Companies that have a formal succession plan in place and have identified leaders from within have a stronger position to negotiate a higher price.
A recent seminar about Employee Stock Ownership Plans (ESOPs) indicated that one of the benefits of implementing an ESOP is that it fosters a sense of ownership in the company. Participants have a vested interest and actively contribute to the company’s success when the plan is implemented fairly. According to a Hewitt Associates study reported in TIME magazine, 9,000 private companies and 1,000 public companies have an ESOP. The total shareholder return for companies with an ESOP was reported at 26% vs. non-ESOP companies at 19%.
Sustainable projected cash flows
Owners must also build a sustainable operating model to grow the business and provide credible documentation (i.e., audited or reviewed financial statements) to support their performance. An investor must consider the growth of the industry in which the company operates. A question to consider is, “Is the industry that the company operates in susceptible to disruption?” Disruption due to technology can greatly hinder a company’s prospects for growth depending on its industry and the industries of the company’s customers.
It’s also important to look at historical trends for a company to determine how it has performed in a recessionary economic environment vs. a bull market. Some industries have certain key metrics that can measure a company’s performance that are called Key Performance Indicators (KPIs). How a company compares to its peers is a good indication of value and the efficiency of its operations.
A customer base and product/service lines with limited concentrations
The development of a customer base in which no single client accounts for more than 10% of total sales should be a goal. A diversified customer base helps to insulate a company from the loss of any single one. The same is true for the company’s products or service offerings. If a company relies too greatly on any one product or service, it could increase the company’s risks if that product or service became obsolete or unnecessary.
Facility appearance and location
Businesses can project “curb appeal” that is similar to the benefits in the home-buying market. A good-looking facility shows buyers that you are proud of your business in every respect and that you have made the necessary investments to keep it going. It also indicates that you have not deferred making necessary capital investments only to create future capital investment requirements for the buyer. Additionally, having a prime location is a good value driver. If a company is inaccessible to potential customers or its location hinders the timely receipt of a product or service, it could limit the growth prospects of the company.
Other value drivers
Other value drivers worth mentioning include:
- Proprietary technology or developed processes
- Market position and brand name recognition
- A historically proven growth strategy
- Developed financial controls to mitigate risks
Many additional value drivers for companies exist, but these are some of the key ones.
Ultimately, all value drivers contribute to stable and growing cash flow. It is the cash flow that determines what a buyer will offer to pay. Buyers buy cash flow, especially that which they expect to increase. In light of this, owners should:
- Implement procedures to increase productivity, decrease costs, and increase cash flow.
- Consider benefits that they receive from the company that are not necessary to the operations.
- Defer unnecessary capital expenditures for discretionary equipment.
- Monitor your company’s Internal Rate of Return (IRR).
Companies that focus on developing and/or enhancing their value drivers will position themselves to attract buyers who are willing to pay a premium!
Executive Vice President
Gary Gibbs has spent his career consulting on financial reporting and changes of ownership for companies throughout the U.S. in diverse industries. He is the firm’s most experienced officer in corporate financial services, including mergers and acquisitions. He works with clients and their legal counsel on economic and financial disclosures, and representations related to business ownership changes. Gibbs has been involved in financial consultation related to business mergers and sales of more than 100 companies involving more than $1 billion. In his capacity leading the corporate finance team, Gibbs oversees a variety of services to companies involved in ownership transition, including development of transition plans, generational transfers, buy side advice, sell side advice, development of acquisition strategies and plans for growth thru acquisitions.
Along with other departments at AGH, the corporate finance team provides buyers and sellers of business interests with a comprehensive portfolio of services to plan, execute and complete such transactions with increased success. Gibbs is a member of the Association of Merger and Acquisition Advisors. In addition to being a CPA and Accredited in Business Valuation (ABV), he has earned the Certified Business Appraiser (CBA) designation from the Institute of Business Appraisers and has earned the Certificate of Education Achievement in Business Valuation from the AICPA.