In today’s environment, it’s important for business owners to focus on the value of their company and what drives it. The objective of this article is to look at value drivers for operating businesses, as opposed to businesses that are asset-based, such as real estate or securities holding companies.
Under the market and income approaches, operating businesses are valued based on the expected return a potential investor could anticipate by holding a stake in the company. In other words, cash flow drives value.
If you want to increase value, you need to increase sustainable cash flow. Notice, we said the sustainable cash flow. While it might look good to have a short-term increase, an educated buyer will see through any non-sustainable increases and adjust those in determining the purchase price. Therefore, cutting capital expenditures or necessary staffing levels in the near term will not drive a sophisticated buyer toward a higher purchase offer.
Here are some tips on ways to dress up the company for sale and increase sustainable cash flow at the same time:
1. Adjust compensation to a level that is representative of what an independent owner, not active in the business, could expect. If a business owner is deriving a living from the business, as many are, then he or she might find other ways to receive the same cash flow. If a business is a pass through entity — such as an S Corp, LLC, LLP or partnership — then perhaps the operator-owner can use distributions to owners as a method of extracting cash from the business.
2. Adjust business expenses to a level that would be anticipated by an independent owner. There are two ways:
- Eliminate any “perk” expenses that owners and executives might be taking out of the business. These are expenses that an independent owner would not expect to pay unrelated executives or employees. Once again, owners can use distributions, instead of these “perks,” to get cash in their pockets. The trade-off for increasing the value of the business is that taxable income (and, therefore, tax obligations) will be higher, however.
- Also analyze the company’s expenses from top to bottom and eliminate items that are not essential to the company’s operations. Most companies find that there is fat to trim. This does not mean expenses should be cut to a point where efficiency and employee morale are affected. However, if a company has not done a cost study recently, it can be an effective way to increase value.
3. Increase revenues. This is often easier said than done. But for established “cash cow” businesses that have been relying on established customer relationships, it may have been a while since they’ve focused on selling new business. Also, a short-term investment in marketing efforts may make the business more attractive to prospective buyers. However, be careful not to take on work for which the business does not have capacity to meet demand or where the potential customer has a credit profile outside of the company standards. Both of these situations could result in a diminution in the overall company value. Don’t rest on your laurels as you start thinking about retirement — it could substantially reduce the price your business will fetch in the marketplace.
4. Review all policies, procedures, processes, contracts and agreements. Although this isn’t directly related to increasing cash flows, a buyer expects to see all of these things in good shape during the due diligence process. Assembling an organized “offering package” can increase the value of the company and expedite the selling process. Here’s a quick list of some items to consider for review:
- Real estate and equipment rental agreements,
- Employment and noncompete agreements,
- Supplier agreements,
- Customer contracts and lists,
- Insurance policies, including company-owned key person life insurance plans,
- Mortgages, lines of credit and other financing agreements,
- Fixed asset listing,
- Technology inventory and licenses,
- Brochures, catalogs, websites and other marketing programs,
- Job descriptions,
- Formal policies and procedures manual, and
- Organizational charts.
5. Tie up key employees essential to the ongoing viability of the business. Potential buyers like to know that when they purchase the company, all of the important and essential personnel come with it. These individuals may be key sales people, operations managers, or specialty skilled employees that have driven value for the business. Keep in mind that not everyone may be on board with the transition, but be transparent where you can be with your key people. Their buy-in to the transition may be your ticket to a higher exit value.
There are many other things that can be done to help increase the value of a business. This article outlines some of the lower hanging fruit. Contact VonLehman’s business valuation specialists today for assistance in getting your business ready for sale. We will be able to provide additional creative ideas that relate specifically to your business. Bryan Setz, Director of Business Valuation Services; bsetz@vlcpa.com; 800.887.0437; or fill out the short form below:
