Although many businesses out there are similar in many ways, each one has value drivers unique to them. These significant factors dictate the overall framework of a business, and looking at them much closely will help a lot during valuations. Domenic Rinaldi highlights one of his most downloaded episodes that discusses the most common value drivers to consider. He explains how they hugely contribute to closing M&A transactions. From people management to complex finance and infrastructure programs, Domenic delves into the most important aspects every buyer must take note of.
Listen to the podcast here:
What Value Drivers Should You Consider During Business Valuation?
I’m recording this episode the week of Memorial Day. I want to take a moment to have a shout-out to all of our service personnel who have served our country and given so much so that we can have such unbelievable freedoms. I’m so thankful for all that they do for us. We’re going to re-release an episode that has been one of the most listened to episodes and one that resonates and should resonate with both buyers and sellers. It’s what drives value in a business and obviously, the numbers matter.
Unfortunately, it’s the thing that most people focus on. They don’t focus on the soft issues of what goes into determining how you evaluate those numbers, what sort of multiple should be applied, and whether or not you should be aggressive with multiples or back off from multiples. Since we released this episode, we’ve seen an incredible number of downloads and a lot of traction. I believe that both buyers and sellers can benefit tremendously from this episode. If you’ve read it again, I think it’s a great reminder. If you haven’t, it’s certainly a great episode. I hope you all have a wonderful or had a wonderful Memorial Day week.
Before we get into this episode, I want to remind everybody. If you want to avoid the common deal pitfalls and the risk of losing substantial dollars, you need to know how ready you are to buy a business. Because I believe proper preparation is so critical to your deal success, we’ve published a catalog of free resources to help you be better prepared. You can access all of these resources on our website at K2Adviser.com/resources. Being prepared is critical to ensuring that you maximize your returns and you minimize your risks. Thank you for being here. I hope you enjoy this episode.
In this episode, I’m going to be diving into one of the components that go into valuing a business. We’re going to be talking about value drivers. I say one component because there are probably 5 or 6 components that you should be looking at any time you’re valuing a business. For example, you’re looking at the financials of the business, understanding historical performance and what the possible growth prospects are for that business. You’re trying to get your hands on comparable transactions for that industry. Doing industry research, how are the target company’s benchmarks that you’re looking at compare to industry benchmarks?
Maybe you are looking at, who could the prospective buyers for that business be? Why is that important? Believe it or not, the type of buyers that could be interested in a particular company could ultimately determine the multiple and the value of that business. The other component is the financeability of that business. Is it likely that you can get a third-party loan to acquire that business? The topic that we’re going to talk about is value drivers. Every business has them. Some are generic and common to every business and there might be industry-specific value drivers that you have to look at. I’m going to dive into, what are the common value drivers that you should be looking at whenever you’re looking at a business? Why are value drivers so important?
I’m going to give you an example. You might have two companies in the same industry with similar top-line revenues and profit margins, but those two companies may be run completely differently and their value drivers might be different. It’s no surprise that those businesses are not going to be worth the same. I’m going to dive into why that’s the case and how you can analyze it. Understanding this is critical so that you don’t overpay for a business and you also don’t lead with an offer that’s insulting to somebody because they do have a great business that you could take to the next level.You might have two companies in the same industry, but their value drivers might be completely different. Click To Tweet
As I mentioned, every business has value drivers. These are things that can move the value of a business up or down. In some cases, they are pretty substantial. There are generic value drivers versus industry-specific value drivers. I’m going to focus on the most common value drivers, things that you should be looking at whenever you’re evaluating a business. As a reminder, I talk to people often about what they should be looking for when they’re out there looking at businesses at a very high level. I always caution people, if you’re looking for a perfect business, there isn’t one. You don’t want a perfect business. You want a business that has upside, things that you can bring your skills and your experience into to improve and take to the next level.
The other things are you want to be careful about buying a business that has to compete with big tech. If you buy a business where you’re going to have to go toe-to-toe with Amazon, Google or any of the other big technology companies, I would think twice about that acquisition. Outsourcing threats, if you’ve got a business that provides a service or a product that could potentially be outsourced, you’re going to be in a race to the bottom. Companies in China, Malaysia and India can do things much cheaper than we can do them here. You have to be careful about looking at target companies that might ultimately have the opportunity to have their services or products outsourced.
The last one is a union versus non-union. This is not an indication as to whether or not I would buy a union versus a non-union business because union businesses are perfectly fine, but you have to go in eyes wide open. If you’re going to buy a union shop, you need to have advisors who understand unions and look at a couple of aspects of that. The prime one is the union that you’re going into, if there’s a pension, is there any unfunded liability in that pension? If so, you want to make sure that that unfunded pension liability is cured before you take over the business. Again, this is an area where you need experts to come in and advise you before you go down that path. With that said, let’s dive into value drivers.
The first one is the financials. It is critically important, but it’s the quality of the financials. When the owner of a business presents their financials to you, are they clean? Are these financials showing the true picture of what the business is doing, month in and month out, year in and year out? How do you know if you’re getting clean financials? You could be looking at a profit and loss statement and what the categories of expenses are. Are they capturing everything? Are there lots of discretionary expenses that are going through the business? If so, in what form are those discretionary expenses being put through the business? Are they things that you can ultimately consider a cashflow to you when you take over the business?
The balance sheet is something that needs particular attention. I’ve seen a lot of balance sheets over the last couple of decades that don’t accurately reflect what’s happening in the business. Some of the big culprits are inventory, where people are not accurately reflecting inflows and outflows in inventory. You can’t get to what’s happening on the balance sheet and how much money is needed to run that business. Loans, receivables and payables, how closely are those managed? How accurate are they? Are there bad debts? You need to look at the quality of the financials. The better the quality, the cleaner those financials, the higher the value of that business because the easier it is to get that business financed if you need to go get a loan.
The next value driver is recurring revenues. These are revenues that are consistently produced month in, month out. It’s different from repeat revenues. The perfect example of a recurring revenue business is insurance companies. People who sell insurance get monthly commissions off of the premiums. That’s a recurring business model. A lot of financial planners work on the same model. They’ll get a percentage of your portfolio on a monthly or quarterly basis. That’s the true definition of recurring revenue. It is different from repeat revenues, where you know you’re going to get clients back on some infrequent basis. When companies have recurring revenue, it drives the value of a business up because there’s some consistency there. You can rely on those revenues coming in on a monthly basis.
The next value driver is owner involvement. When you look at a business and you’re analyzing it, one of the key components is, how much time and effort does the current owner put into that business? Is the owner involved in lots of the decisions, day in and day out? Is the owner removed from the business? Does the business operate without their involvement? One of my litmus tests on owner involvement is, can that owner take a month off, go somewhere and not have to be involved in the business at all? If that’s the case, then you know you have a business that’s fairly turnkey. When you’re walking into a turnkey business, the value of that business goes way up because it’s not dependent on that owner. Chances are, the owner is not out there leading the sales efforts and not involved with clients, setting strategic direction and managing the business from a strategic level. You want to be careful that they don’t have their hands in the weeds, because if they do, it drives the value down. The risk goes way up when you take over a business that the owner was so involved, that there are going to be some hiccups during the transition. Those types of companies tend to get a lower value.
Client Acquisition Process
Next is the client acquisition process. How easy is it for that company to generate new clients and keep the clients they have? In order to understand this, you need to look at the sales and marketing capabilities of that company. Do they have good, solid sales programs and salespeople that are out there generating business on a regular basis? Is the marketing function behind those salespeople generating good brand awareness and leads for that sales organization? Is it all working like a well-oiled machine? What are the costs of generating those sales? You want to be analyzing that client acquisition process to see how solid it is and what’s the cost of maintaining it. If it’s a well-oiled machine, you’re going to look at paying a little bit higher value for a business like that versus if you have to come in and build a sales and marketing machine or retool what’s there.
The next value driver is the quality of the employees. When I look at the employee base, I’m looking at, how long are people there at the company? What’s the turnover rate? Are there any choke points in the employee base? What do I mean by that? Are there 1 or 2 employees that if they weren’t there, the business would come to a screeching halt? It is the same way I talked about the owner being so involved in the business that if they go away the business stops. You want to be looking at analyzing that business to see if there any employees that are potential choke points in the business.
A perfect scenario there is that everybody is cross-trained and no one person has all of the keys to the kingdom. I’ll give you a perfect example of this. I have a client who had a CFO who was the only one who knew how to close the books at the end of the month and that CFO resigned. It is no surprise that business came to a screeching halt. They had to pull in an expert from the outside. It took a couple of weeks for that expert to get their arms around the business and start getting the books closed on a regular basis. You want to be looking for things like that in a potential target company to see if there are risks.
The other thing is, how autonomous are the employees? Do they need the owner’s permission for every decision or everything that they want to do? Do the employees have a fair amount of autonomy to take risks? Calculated risks are nothing that’s going to put the business in jeopardy but risks nonetheless, which will feed in their culture. You’ll see that when the employee base operates somewhat autonomous, that there’s generally a pretty good culture. It means that there’s trust in the business and the owner trusts those people to operate the business day-in and day-out.
The last thing I’ll mention is non-solicitations. I’m not mentioning non-competes because it is hard to enforce. You should be looking to see if the employees have non-solicits. To the extent that if the business has non-solicits, the value of that business goes up because that means those employees can’t just leave and then go target the clients or the vendors of the company. These are all the things when you’re analyzing the employee base to determine, does the value go up or does it go down based on some of these?
The next thing is clients. The first thing I’m looking at when I’m evaluating and analyzing a client base is, are there any concentrations? Does any one client represent more than 10%, 15% of the company’s revenues? If the company does have 1 or 2 clients to represent more than that, I’m probably decreasing value a bit for this one component. I’m also looking at, what’s the longevity of those clients? What’s the satisfaction level of those clients? Oftentimes, you can go online and look at surveys or reviews to see what the satisfaction level is.You don’t want a perfect business. You want a business to bring your skills and experience to improve and take to the next level. Click To Tweet
If you can’t determine that because the business doesn’t operate in a public way and you’re serious about the business, one of the things you can do is ask the owner to do a third-party satisfaction survey with the clients if you get far enough down the road in diligence. That would need to be masked. Nobody needs to know that the business is for sale, but it’s a good way to test whether or not the clients are satisfied. The other thing you want to know is, are those clients under contract? What are the terms and conditions of those contracts? Can they be easily broken with 30 days’ notice? Are there some penalties in the contracts that tie the clients to the business in a good way?
The next value driver that you want to be analyzing is, what are the growth prospects for that business and that industry? Has the company built a foundation that you then can come into and grow to the next level? What are the overall industry prospects? Is this an industry that’s on the rise? Is it stable and mature and growing at a low rate? Are there some headwinds in that industry that may mean that you’re going to have to retool that company in the next 2, 3 or 5 years and diversify to accommodate some of those headwinds? Understanding all of these things should go into factoring where the ultimate value shakes out.
The next value driver that I like to look at is barriers to entry. Quite simply, how easy is it for competitors to enter that industry? As you can imagine, there are some industries where there are low barriers to entry. Anybody can set up a shop and all of a sudden, you have a new competitor. Whereas there are others that either has patents or processes in place. They serve such a specific niche that the barriers to entry are high. When they’re high, you’re going to be giving that business a little bit more consideration when it comes to value.
The next value driver I’m looking at is vendors. The same with clients, I’m looking at concentrations here. Is the business tied to 1 or 2 vendors? Such that if those vendors decided to tighten up credit or in the case that I had with a client, they had a vendor pull their product line from them completely. That product line represented about 40% of that client’s business. Overnight, 40% of our client’s business went away. Now, they’re scrambling to replace that vendor, which is going to take some time. You want to be careful when you’re looking at vendors in the company. Are there concentrations? How long have those relationships been around? What are the terms of those relationships if you were to take it over? If the vendor base is diversified and there are lots of vendors that the company has, maybe they’re focused on one vendor at the moment, but you know there are multiple vendors that they could be using, then you’re looking at the value a bit differently there.
The next thing is the infrastructure. What’s the infrastructure of the business, the quality of the systems and the processes that the owner has put in place? When you’re out there searching, you’re going to come across businesses that don’t have good systems and processes. You’re going to decrease the value for that. Where there are good systems in place and documented processes, maybe even an owner’s manual that gives you the footprint operations on how the business operates day-in and day-out, when owners have taken the time to do that, it’s an indication they’ve taken time to do lots of other things right in the business. I always love when I see that in a business. Infrastructure matters and will determine whether or not you’re decreasing or increasing value.
I mentioned key performance indicators. What are the benchmarks in that industry? For example, what are the common costs of goods sold in that industry? Using that as a benchmark and then comparing the business that you’re looking at to what the industry benchmarks are. What’s the cost of labor for a business like that? Looking at what the cost of labor percentages are in your target company, seeing and comparing how that business operates to industry benchmarks. Is there any number of benchmarks that you need to be identifying? This is somewhat of an industry-specific item. There are lots of ways to get these industry benchmarks. There are lots of research reports out there. If you have a good advisory team, they should have access to many of these industry reports.
The other thing is financeability. Is that business financeable? This goes back to the quality of the financials. If the business has good clean books and records and the quality of those financials is exceptional, it’s going to be easy to take those financials to a bank and secure a loan to acquire the business. If those financials are not in great shape and it doesn’t depict what’s happening in the business, it’s going to be much harder for a bank to get behind providing a loan on that business. One of two things happens here. One, either the value of the business goes down because the banks lose interest or confidence in that business or you’re not going to be able to get a bank behind the deal at all. Maybe you’re going to have to ask the seller to finance this business because the business financials aren’t in a condition that you could take it to a third-party lender.
The last item is a grab bag of miscellaneous things that I’m not going to go through but this is where it gets specific to a business. What are the ongoing capital requirements of that business? There is no surprise here, the more capital required to operate a business, the lower the value of that business because that means you’re going to have to take more dollars out of your pocket to maintain and grow the business. What’s the legal history of that business? Does that business has a history of lawsuits and workers’ comp claims? Is it a clean business and there aren’t legal issues inherent in the business that will drive the value up or down?
Patents, whether or not the quality of those patents has been perfected. How long is left in those patents? It is something to be looking at that will drive value. The next is technology. What is the underlying technology that the business operates on? Does it have to be upgraded at any time in the next 2 to 3 years? Is it solid and can it accommodate growth into the future? As you can imagine, you’re pulling together all of these value drivers after you analyzed them. You’re doing a checkmark of up and down arrows. One area might be driving value up, while another area might be driving the value down. You have to take all of these value drivers into consideration and look at them on a holistic basis so you can determine where does the value range. Every business has a range. Where does the value range come out for a business like that? I’m going to cover how you arrive at a value in more detail in a future episode and how value drivers fit into the overall trend and how you use it as a data point in looking at the whole business.Where there are good systems in place, it’s an indication that owners took time to do lots of other things right in the business. Click To Tweet
This is where an experienced deal team by your side can be invaluable. Having people who have done lots of deals, who understand all of these things and how they drive the value up and down is critical. You need to surround yourself with M&A experts who have been through it many times and have a track record of success. If you’re in the middle of a deal now and you need some help analyzing a business or understanding where that value range is, please feel free to reach out to us. We’re happy to help you think through that. I also urge you to take advantage of the free buyer acquisition assessment on our resources page at K2 Adviser. This assessment was designed to help you understand how ready you are to buy a business and where the gaps might exist so that you can close those gaps and get ready to get out in the marketplace and acquire the business that’s right for you.
If you would like to reach out and learn more about how we can help you on your business ownership journey, please fill out the contact form on our website and we’ll be in touch. I hope you enjoyed this episode. If you enjoy our content, please remember to subscribe and review our show. I look forward to seeing you again in the next episode. Until then, please remember that scaling, acquiring or selling a business takes time, preparation and the proper knowledge.
Love the show? Subscribe, rate, review, and share!
Join the M&A Unplugged Community today: