by Paul Pillat
Many business owners we meet with are contemplating selling their business at some point in the future and want to know what strategies can be used to enhance their value and hopefully achieve a higher sales price. In order to do this, we often need to educate owners as to some of the primary variables that drive business value and can increase your business valuation.
The most logical starting point is to increase recast EBITDA. Recast EBITDA represents earnings before interest, taxes, depreciation and amortization that are adjusted or “normalized” for owner-related discretionary items, one-time expenses, discretionary business practices and normalized capital expenditures. Recast EBITDA is important because it is the one metric that most directly affects the economic value of a business.
An obvious first step is to increase sales through internal or external growth. Opportunities for external growth may be available through acquisitions, when carefully managed, which are both accretive and self-financing. If careful deal structuring results in little or no out-of-pocket cash, the consolidation math definitely works in the acquirer’s favor.
Lowering cost of goods sold and hence enhancing a company’s gross margins can also result in substantial value enhancement. Upgrading a company’s purchasing function and using “cutting edge” inventory management systems are two of several strategies that a company can use to manage what is typically the largest cost driver. Increasing efficiencies in “through- put” production will usually result in a leaner manufacturing process and lower costs.
Control of operating expenses has an immediate and direct impact on company earnings. A budget process tied to longer-term planning is essential in controlling planned versus actual expenses. Expenses should be managed to the lowest reasonable level possible.
Another important and often overlooked way to increase economic value in a company is via reduced financial and operational risk. Financial risk can be reduced by reducing the cost of capital through the use of debt to support equity. The debt market should be tested on a regular basis to maximize the benefits of lower rates and competitive terms and conditions. Operational or business risk can be reduced by establishing long-term contracts with vendors and sales contracts with customers.
Two other risk areas that also have an impact on a company’s economic value are customer and management concentrations. No single customer should ever, if possible, account for more than 25% of a company’s total sales. Broad customer bases mean that loss of a single customer will have minimal impact on the business. Likewise, an owner needs to be able to demonstrate that he has a team of capable employees and that he or she is not absolutely essential to the success of the business. This is an important practice that all company’s need to consider and plan for in order to reduce the impact on a business in the event of a unexpected death or disability of a key employee.
Finally, many mid-sized companies do not know profitability on their various product or service lines. Knowledge of product profitability begins during the budget process and has a direct impact on a company’s ability to use their capital more efficiently. Lack of knowledge as to product profitability is correctly viewed by outsiders as increased risk which translates into reduced value. Also, each capital investment should be analyzed from a risk/return standpoint and payback period to determine its suitability and to maximize the deployment of available capital.
Obviously, there are many additional factors which can impact the value of a business. Value variables are also industry specific in some cases. The above discussion is not intended to be all inclusive but rather a starting point for an owner wishing to perhaps better understand some of the drivers that impact the value of their business. Cornerstone regularly works with business owners’ in analyzing a variety of options for growth, value enhancement and exit strategies.