When we think of real estate, there are some common features that tend to result in some houses selling at a higher price. These include the property’s location, its size, the quality of its kitchen and bathrooms and how well the home is presented. Similarly, when it comes to businesses, there are some common features that support positive sales results.
Very simply, businesses with a high potential for growth and minimal risks will demand a higher price. However, like houses, businesses must be built on strong foundations in order to achieve their maximum value.
What can you do to increase the value of your business?
Here, we consider the key components that well help you achieve maximum value for your business.
As you can see from the above valuation formula, increasing the earnings level of the business can have a multiplier effect on business value.
When looking honestly at their businesses, many business owners could identify key areas where tighter management would generate an uplift in earnings (and valuation as a consequence).
Things to consider:
- Do you really know which customers and products are making you money and which aren’t? Clients are often surprised to find that some of their products or customers are loss making.
- Where might you be able to increase prices? Whilst there are always some products or services where demand is elastic to price, there are often others that are less price sensitive.
- Do you have the right people in the right roles? Sometimes, businesses can carry the wrong people simply because they do not have the courage to make the hard decisions. Make sure that you are not incurring costs that aren’t value enhancing.
However, it’s important not to seek to inflate profits by reducing investment in important functions such as marketing, repairs and maintenance and training. Buyers will be concerned about the impact that superficial attempts to bolster short term profitability may have on the longer-term growth outlook for the business.
Understanding each of the elements that typically go into a business valuation will help you to determine what you need to do to increase the value of your business.
Very simply, most (but not all) businesses are valued based on a multiple of their current, maintainable earnings before interest or tax (EBIT) or EBITDA (earnings before interest, tax, depreciation and amortisation).
The multiple that’s applied is generally a reflection of two key elements:
- The businesses’ growth expectations
Businesses are typically sold on a cash free/debt free basis and so a deduction is made to the amount of any net debt in the business for the purposes of deriving the company’s equity value.
A very basic example of how the equity value in a company may be determined is included in the table below.
|Value of owners’ equity||$2,500,000||$3,500,000|
Building on what makes your business unique and focusing on its competitive strengths as a part of a strategic plan is vital for maximising value.
We encourage business owners to spend more time working ‘on’ rather than ‘in’ their businesses to identify current market trends (both in Australia and overseas) and to determine how the business might be able to capitalise on any growth opportunities. Such strategies may include:
- Net Promoter Score – determining how likely it is your customers would recommend your business
- Responding to customer feedback and unmet customer needs
- Considering how one of your products may be adapted to meet a potential need in a different industry
- Copying business models that are working well in your industry overseas, but which have not yet been adopted here
- Expanding into other geographical areas
- Considering strategic alliances, e.g. potential partnership with a distributor in an overseas market
- Acquiring complementary businesses
However, it’s often much easier to develop a growth strategy than to implement it. Thus, some buyers invest in the people in the business as much as the products or services it provides. Moreover, buyers tend to favour businesses with management teams that can operate the business effectively and deliver on strategy, even after the current owners exit the business.
If the business is not currently at a stage where it can afford a top management team, then it may be prudent to assemble an advisory board that can help guide you through the implementation of a growth strategy and hold you accountable to it.
Purchasers generally will not pay a high multiple for a business if they are concerned that the profitability may not be sustainable. Thus, it is also important to manage risks.
A comprehensive risk management program that is integrated into your organisation’s operational processes can address uncertainty, assist in decision making, improve overall performance and ultimately create value.
Refer to our <risk management checklist> for some recommendations on key risk areas that can often be managed better in private businesses.
One common factor that is often overlooked in building the value of a business is the appropriate management of cash and debt.
There are a number of reasons why clever cash and debt management can enhance the value of a business. These include:
|1.||Debt can increase equity value|
|Many small business owners are scared to be locked into bank debt. However, debt funding is typically cheaper and more tax effective than equity funding. Banks will usually require the borrower to pay interest at 7%-10% of the borrowed amount. Whereas an equity investor will usually require a return of at least 15% on their investment. Therefore, debt funding can be an effective way to support growth and maximise value for existing owners.|
|2.||Enhances the return on assets employed in the business|
|The faster you can convert inventory and debtors into cash and the longer you can hold off paying your creditors, the lower your working capital levels will be. Thus, the business will generate a higher cash return on the assets that are employed. Managing your working capital can also help you fund the day-to-day operations of your business without investing more of your own capital or running to the banks for debt funding.|
|3.||Businesses are normally sold on a cash free debt fee basis|
|Businesses are usually sold with enough working capital to maintain current levels of pre-sale earnings. Surplus cash is typically excluded from the working capital that is transferred with the business. The vendor usually keeps all the cash that was in the business prior to sale. The more working capital (debtors and inventory) vendors can convert into cash before settlement, the more cash the vendor keeps. Therefore, how working capital is managed can have a direct impact on the effective consideration a vendor receives for their business. So the more cash the business collects prior to the sale of the business, the more you will take home when you ultimately sell your business.|
However, a business can have too much debt so that instead of increasing business value, it begins to erode it. Debt outstanding at the time of sale is usually settled by the vendor out of the proceeds of the sale. If debt levels exceed the sales price, the business essentially has no value to the current owner. Hence, it is important to closely manage cash and use the right mix of debt and equity funding to maximise value.
Buyers will normally be looking to grow your business. They will normally not pay maximum value for a business that does not have good systems and processes, as the ability to achieve economies of scale will be limited.
Good systems and processes typically include:
- A customer database which can be very attractive to buyers – as they may want to cross-sell their services to your customer base
- Financial statements that enable management to quickly make appropriate decisions (ability to derive and report on profit by product business segment)
- Employee relationship management systems, including up to date employment contracts with appropriate restraint of trade agreements in place with key members of management
- IT system that enables customer information (behaviours and buying patterns) to be captured and analysed
- Perpetual inventory system managing and reporting on the levels of stock
- Employee share or incentive schemes that help attract and retain key employees to your business
It’s particularly critical that financial statements are accurate and reliable. As discussed, buyers may be purchasing based on a multiple of EBIT or EBITDA and will typically want the accounts to have been correctly prepared in accordance with Accounting Standards. Buyers will walk away from deals, or negotiate much lower prices, if your business has poor financial records.
Good reporting systems also provide helpful insights that support operational decision making to help drive improved financial performance and a higher business valuation.
People decide to exit businesses all the time. Some execute a long-term plan, others are presented with an unexpected opportunity to sell. In either case, the person selling the business wants to maximise their return from the years spent in the business.
However, selling a business is a much more complicated process than most business owners expect, frequently taking more than six months and requiring a significant proportion of management time to answer due diligence questions. Thus, if a business is not prepared for sale well in advance, the management can be distracted from the business at a time when it is paramount for the business to perform well – resulting in buyers trying to negotiate a lower price if the financial performance deteriorates.
How can we help
At William Buck, we understand that running your business professionally and profitably for the benefit of the current shareholders is an all-consuming priority for owners and their management teams.
Value maximising strategies result from businesses that are established and run with a focus on long term success.
We can assist by helping you to establish the systems and processes that optimise business performance and mitigate risks. These are typically the same processes, systems and activities that will help you maximise value when you sell your business.
For more information on increasing the value of your business, call a William Buck advisor today.