What color of car would you rather buy? Based on your personal preference, the answer to this question will affect how much you are willing to pay for a vehicle that is identical in all aspects other than color. You might ask what does this have to do with the Market Value of your business? Simply put, traditional valuation techniques generally ignore one important factor in their calculation, the buyer.
A traditional valuation certainly has its uses, particularly for IRS and litigation cases, such as determining value for a divorce settlement. However, they usually all assume a willing buyer exists and that this buyer doesn’t have any personal preferences outside of the normal industry standards.
Let’s go back to the car example, assuming a dealer has two used cars that are the same make, model, year, etc., but one is blue and the other is silver. They will almost certainly be priced exactly the same. However, if your preference is for a blue car, you would no doubt buy the blue car. In fact, the dealer would have to discount the silver car for you to consider that as an option. Therefore, your preference has effectively determined a higher value for the blue car over the silver one, despite the market suggesting that they are both worth the same.
So how do you apply this logic to the value of your business? If you’re thinking about selling your business sometime in the future, you probably have no idea of who will buy it and what their preferences are, so what can you do now to position your company to maximize value from an exit, and where do you start?
In terms of business acquisitions, there are generally two main buyer groups, each with very different views of what is important to them. These groups consist of financial and strategic buyers. Financial buyers generally consist of individuals or groups of individuals looking to invest in a business, whereas a strategic buyer is normally a company looking to add to its existing operations.
As an example, assume that after some initial research, you determine that the most logical and likely buyer type is a strategic buyer. You determine, based on other acquisitions in your industry, that the primary focus of most buyers is the quality of the customer base being acquired, rather than say the management team, who will most likely be surplus to requirements after the deal. Therefore, if the last five years have been spent investing and training a good management team these efforts could be ignored by the buyer who will discount this aspect of the business. However, if those efforts had been channeled into increasing and maintaining quality customers over the same time frame, the buyer would most likely pay a higher price for the business.
The above example highlights the impact of focusing attention on the right aspects, which we call Value Drivers, of the business to make it the most attractive to likely buyers when it comes time to sell in the future. Value Drivers can include, among other things:
- Customer Base
- Management Team
- Products & Services
- Competitive Advantages
- Quality of Financial Reports
- Financial Performance
While you can control and manage most of the value drivers of your business, other aspects specific to a buyer will also determine the potential value that they can justify paying, including:
- Risk Tolerance
- Required Rate of Return on Investment
- Ratio of Equity and Debt used to purchase the business
- Cost of Debt
The impact of these factors is not possible to plan for but is buyer specific and will result in different values being placed on exactly the same business by different buyers. They should be considered when negotiating an actual sale with actual buyers.
In order to position your business to maximize value when the time is right, we recommend going through the following exercises:
- Undertake a market analysis of who is buying similar businesses to determine the most likely buyer type for your business.
- Review recent transactions to determine what values are being achieved.
- If possible, contact ‘typical’ buyers anonymously to understand the value drivers they are primarily looking for in an acquisition target.
- Understand the level and source of debt that could reasonably be secured to finance an acquisition of your business so that you can estimate the likely ratio of debt and equity.
- Perform a strategic planning session for your business to ensure the long term goals of the Company are focused on growing the right value drivers based on your analysis above.
- Create Key Performance Indicators in order to track specific value drivers on a monthly basis and include as part of your monthly financial package to ensure efforts are maintained over time.
- Review the process on an annual basis to ensure any changes in buyer types and value drivers are known and addressed in a timely manner.
If you have questions about knowing the value of your business, please contact Austin Buckett.