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Maximizing Business Value
May 8, 2017

© 2017, by Daniel T. Jordan, ASA, CBA, CPA, MBA

1 In order to maximize business value it is necessary to first identify the variables over which a business owner has control. Then we can derive the strategies to maximize the value of the business over time.

The most important variables over which a business owner has control that determine the value of the business are the following:

 

• Growth Rate
• Discount Rate

Growth Rate

A business owner can maximize the growth rate of cash flows by managing the business more efficiently and effectively. The business owner must make sure that every action he takes sales will increase more than expenses.

Minimizing tax liability is a strategy all business owners think about. But when it comes time to obtain financing or sell the business, buried personal expenses and assets can create a problem in determining the true cash flow. Buyers and bankers won’t always give credit to many of these items. As a result, the cash flow can be suspect. And when you apply a multiplier to determine the value of the business, the results can be disappointing. It is in the best interest of a business owner to show a healthy bottom line at least three to five years preceding the sale of their business to get the highest price possible. Also, a business is a lot easier to sell if the owner “goes legit”.

The faster the owner is able to increase the cash flows, the more valuable the business will be. However, this requires a greater degree of structure, organization, and professionalism. If the firm grows to a size large enough to be attractive in the Mergers & Acquisitions market or for purchase by a public company, then the likely buyers will be well-diversified investors. Diversified investors have less risk, hence, the discount rate is lower, which results in a higher value. Moreover, diversified investors are strategic buyers who often achieve synergies or economies of scale and therefore are willing to pay a higher price than a financial buyer.

Discount Rate

The discount rate reflects the risk of the Company and is the return the investors require to invest in the business. The lower the risk, the lower the discount rate and the higher the value of the Company. There are many actions, an owner can take to reduce risk. The impact of reducing the discount rate by as little as 1% to 2% can be substantial—much larger than managing cash effectively.

Increasing the growth rate of cash flows and reducing risk are the two most powerful ways one can increase the value of the business. Increasing the growth of cash flows is mainly a matter of being able to increase net income. But how do we reduce the risk? In order to answer this question, we have to identify first the various types of risks:

There are two types of risk: risk inherent in the business and the risk to the buyer.

Risks Inherent in the Business

The risk inherent in the business consists of operational risk and financial risk.

Operational risk factors are those risks that exist in the nature of the business. They include the business cycles of the industry, fixed costs, and dependence on the owner. A high fixed cost operation has additional risk that a low fixed cost operation does not have. Therefore, you need to receive enough of a return on it to justify the risk.

Financial risk arises from the presence of debt financing. The presence of debt always causes volatility to rise. Since volatility is risk, the more debt, the more risk. Thus, debt increases the risk of the firm.

Risks to the Buyer

The most important risks to the buyer are the following:

  • The Risk of High Dependency on the Seller
  • The Risk that the Seller is Dishonest
  • Special Relationships with Customers
  • Few Large Customers
  • Lease Terms

The Risk of High Dependency on the Seller
The largest single risk to most privately held businesses is overdependence on the business owner. Some businesses can’t survive without the owners trying to do everything themselves. And there are no key employees in place to help manage the operations. Buyers for businesses like these may be concerned if they themselves can’t replace the skills and experience of the owner. As a result, these businesses may have very little value to anyone else. Business owners who don’t delegate need to make a strong effort to have experienced key people in place before they ever try to sell their companies. You need to hire and train excellent employees, creating a logical system of organization with good structure and procedures, being computerized and very professional.

The Risk that the Seller is Dishonest
To reduce the fear of seller dishonesty, the seller could get audited or reviewed financial statements for at least three and preferably five years before selling the business. At the very minimum, make sure that the business has a set of financial statements and annual tax returns that are easy to understand and make sense to anyone who has to review them.

Special Relationships with Customers
Special relationships that business owners have developed with customers can be a real issue when selling the business. A new owner may have a problem continuing that relationship and this could jeopardize the sale of the business. It is recommended that business owners begin delegating any special relationships with customers to other company employees as soon as possible.

Few Large Customers
Many companies have a single customer or a few large customers that dominate their overall sales. But when it comes time to sell the company, this becomes a huge problem. Most buyers won’t look at a business whose revenues could drop dramatically after closing from the possible loss of a few big customers. Business owners have to find a way to diversify their customer base before they ever decide to sell their business.

Lease Terms
The lease terms of the business space can be a major consideration for a buyer. For example, a retail business with a long-term lease at a good location can be attractive. But a long-term lease on a business needing more space to grow could be a detriment. Or there might be concerns for an expiring lease when the landlord might demand a large increase. When it comes time to negotiating a new lease, business owners must carefully think through the timing of their plans for exiting their business.

Summary

The actions you can take to maximize value are to reduce the risk of the business (e.g., less dependence on owner) and create the highest possible sustainable growth in cash flows. The businesses that have been structured to sell easy-to-read financials, profitable bottom line, key employees in place, growing market, quality products and services are the ones that will see the light after the tunnel.

Business owners who are too aggressive on minimizing taxes and, thus, understate their profits might be very disappointed in the value of their business when it comes time to sell.

Understand what buyers are looking for and put plans in place to make your company attractive to a “best fit” buyer.

Endnotes

  1. “How to Value Your Business and Increase Its Potential”, Jay B. A
    brams, McGraw-Hill, 2005, p. 141-170.