Most business owners shy away from the topic of valuation. First, it can be a complicated topic, and for some business owners who do not feel confident approaching it, the natural tendency is to pretend it doesn’t even exist. Second, owners—particularly those of small privately held businesses—do not feel as though valuation applies to their situation. Maybe they are just starting out and the business is reflective solely of their personal goodwill and not a robust enterprise above and beyond themselves, or they are an established owner with no intention of selling. However, as an owner, regardless of whether you sell tomorrow or never, understanding the value of your business and what can drive enterprise value is critical. Waiting too long to focus on value creation in your business can lead to a stagnant business with fewer fruitful exit options when the time comes to part ways. In future sections of this article, I will discuss key considerations of a valuation to help you plan strategically for future growth and build value in your asset.
How Valuations Are Used
The most commonly understood purpose of a business valuation is when a business owner looks to sell the business or potentially acquire another one. However, several other purposes exist, including:
- Gift and estate planning and taxes
- Employee stock option plans and other incentive programs
- Shareholder disputes
- Shareholder/operating agreement requirements
- Asset division during a marital dissolution
- Bank lending requirements
- Liquidation during bankruptcy filings
It is important to understand that the approaches to determining value are not the same. Preparing a valuation for a potential business sale to a target acquirer may yield a higher value than preparing a valuation on a hypothetical transaction for gifting a small block of shares. A valuation analyst must consider the context and the purpose of the valuation. However, there are common attributes among all business valuations that owners can apply to help improve value. Often, these attributes are considered “value drivers.”
Value Drivers
A valuation of a privately held business has countless variables incorporated to appropriately assess the risk of the business. Like any other investment, the risk largely will determine the price paid—the greater the risk, the cheaper the investment will be. Characteristics that can drive value may vary based on the stage of the business cycle your business is in (launch, growth, maturity, decline), the type of business, or even your future aspirations for the company. Below are a few examples of common value drivers in small businesses.
Controls
Regardless of how small the business may be or how early in the business life cycle you may be, establishing controls is an easy method to reducing risk. In the practice of working with small to medium-size businesses, a common situation is the owner who was late to the game: “We did have a bookkeeper that was handling all of the checks. We caught them stealing money, and now we have a process where two people have to sign a check.” Establishing controls before it is too late can help eliminate cash shortfalls and a limitation on your company’s growth prospects.
Key Person Risk
In the context of small businesses, the reliance on one or two individuals can increase risk, thereby decreasing value. Relying on one individual in the company to be responsible for critical components, including (but not limited to) building customer relationships, building supplier relationships to get better pricing, or maintaining employee loyalty, can lead to higher key person risk. In several valuation contexts, key person risk can be incorporated into the future cash flow of the business, the discount rate that reflects the overall level of risk in the business, or a discount applied at the entity’s equity value level.
Appropriate Compensation
Incorporating the appropriate compensation structure for your business early on can lead to quicker business growth with a more stable workforce. When thinking about the structure you want to implement, it is important not only to think about the cash that a person will receive, but also how they will be incentivized to receive it. For example, consider a service industry that bills by the hour (e.g., lawyers, architects, accountants, consultants, etc.) for projects it delivers to clients. If each employee is given a bonus based on the number of personal billings in a year, this can lead to employees having blinders on as it pertains to the overall performance of the business. Considering both individual and firm-wide performance objectives when calculating bonuses can lead to more balanced outcomes and prevent selfish tendencies.
Customer and Supplier Concentration
High customer and/or supplier concentration means that few customers/suppliers make up a large percentage of the overall business. For example, at a catering company that works with only three companies, there is more pressure to have each of those companies generate business for the caterer. Expanding the number and type (e.g., industry, commercial v. individual, geography) of customers reduces the risk of one customer leaving and significantly hurting the financial position of the business. The same is true of suppliers. A high concentration of business going to one or two suppliers leaves a business susceptible to price changes, problems with the availability of goods, and the potential for significant events that can hinder purchasing.
Access to Capital
Debt traditionally has a negative connotation. Many individuals believe that limiting debt is an important goal. As a business, being debt-free is not always the best situation. When debt is used proactively, it can be a tremendous tool for creating value. Access to a line of credit or a loan agreement allows you to put someone else’s money to work to improve your business at a greater return than the cost of the debt. You can use a line of credit to help finance working capital or get a term loan to finance equipment, acquire a competitor, and so forth.
Strict on Collections
Asking for money is not the easiest conversation. However, if you are a business owner, particularly in a service business, collecting money from customers in a timely fashion is critical. The sooner you can collect customer receivables, and the later you are able to pay your vendors, the more time you have to use your cash to grow your business and increase value. Employees also will be happy that, come bonus time, you are not bemoaning a lack of funds just because you are bad at following up on receivables. These points aside, balance is important. If you have terms that are too tight, you also could lose some business.
Lease Arrangements
For brick-and-mortar retailers (including restaurants) in particular, lease agreements can play an integral role in a valuation. Unfavorable lease terms compared with benchmarked industry players, near-term lease expiration, and a history of difficult landlords are some of the characteristics that can drive up the risk profile of a business and, therefore, lower the value of the business.
The topic of valuation can be complex, and at Willamette Management Associates, our role is to assist companies with estimating valuations for various purposes (e.g., mergers and acquisitions, litigation, shareholder buyouts, gift and estate planning and taxes, etc.) and consult with companies on how to best drive value for their business. When clients choose us, they are selecting a partner committed to helping them achieve their goals. Our clients receive personalized insights from advisors they can trust. Regardless of the size of the business, our goal is to provide you with smart advice and the tools necessary to maximize value.
This is a contributed post by Danny Young, manager at Willamette Management Associates, a Citizens company in Boston. Danny has extensive experience performing valuations for companies in a wide array of industries and providing consulting services as they pertain to employee compensation and value generation. When Danny is not valuing companies, he spends time on the north shore with his wife and puppy, golfing, and finding the best food Massachusetts has to offer.
The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In authoring this discussion, neither the author nor Willamette Management Associates, a Citizens company, is undertaking to provide any legal, accounting, or tax advice in connection with this discussion. Any party receiving this discussion must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this discussion.
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