Menu
Background
One of the main differences between a public company and a private company is in the valuation. A public company has its stock defined by the market second by second, while private companies do not have a valuation from the market unless they pursue one. This results in a valuation gap between buyers and sellers with sales of private firms.
Investment bankers and business brokers in a 2015 Pepperdine survey said about one in three of their engagements to sell companies terminated without the deal closing last year. The top reason reported by these investment bankers for “deal breakers” was a valuation gap in pricing. Brokers also reported the valuation gap as one of the top reasons, along with what was described as unreasonable non-price demands by one of the deal parties. In fact, roughly 20 percent of the busted deals for these brokers and bankers were due to a valuation gap.
According to this Forbes magazine report, about two-thirds of nearly 1,000 business owners surveyed by Pepperdine University’s Private Capital Markets Project expect to transfer their ownership in the next ten years. The proper valuation of a business is key to designing the strategy of a company in transition and it is paramount to understand how key factors affect the value of an organization. These factors are:
Free cash flow generation
Revenue growth potential
Owner dependency
Industry outlook
Local and regional economy status
Free Cash Flow Generation
Warren Buffet, arguably the most successful investor of all time, developed a strategy for valuing a business that is pretty simple: The main measure of value is free cash flow generation. Warren Buffet points out that what matters the most is the amount of cash a company can provide to its shareholders.
As Investopedia explains:
Cash flow is the measure of cash into and out of a company's bank accounts. Free cash flow, a subset of cash flow, is the amount of cash left over after the company has paid all its expenses and what was spent for capital expenditures (reinvested into the company). You can quickly calculate the free cash flow of a company from the cash flow statement. Start with the total from the cash generated from operations. Next, find the amount for capital expenditures in the cash flow from investing section. Then subtract the capital expenditures number from the total cash generated from operations to derive free cash flow.
“Managing” or “representing” net earnings in a favorable light can be accomplished with various legitimate accounting methods. However, free cash flows are really difficult to “manage.”
Many business owners think that tangible assets drive the value of a business. While assets like buildings, machinery, vehicles, and land are important, the key factor is how much cash these assets are able to generate.
For instance, Walmart and Google generated exactly the same amount of free cash flow in 2015, 16 billion dollars. However, Walmart needed 116 billion dollars in fixed assets to generate this free cash flow while Google only needed 29 billion in fixed assets to generate the same 16 billion.
Google’s business model requires far less fixed assets than Walmart to generate the same amount of free cash flow and the results of this fact are represented by the difference in market valuation of the two companies in April 2016:
Walmart: $217 billion
Google: $508 billion
Free cash flow generation must be the starting point of your valuation.
Resolution 1: I will focus on free cash flow generation above revenue generation.
Revenue Growth Potential
When an investor calculates the value of a company, past performance will always be a consideration. But future potential growth, while harder to measure, is more important than historical performance. McKinsey analyzed more than 3,000 companies between 1980 and 2012 and the results were:
Growth yields greater returns. High-growth companies offer a return to shareholders five times greater than medium-growth companies.
Growth predicts long-term success. “Super Growers”—companies whose growth was greater than 60 percent when they reached $100 million in revenues—were eight times more likely to reach $1 billion in revenues than those growing less than 20 percent.
Growth matters more than margin or cost structure. Increases in revenue growth rates drive twice as much market-capitalization gain as margin improvements for companies with less than $4 billion in revenues. Further, it was observed that no correlation exists between cost structure and growth rates.
Growth rates above average, while very difficult to achieve, have a direct impact on the value of a company. The Business Insider blog states some of the challenges a growth company will face:
Growth needs access to additional capital. Few companies are able to grow without the need of additional external resources. You have to have access to the right sources of capital that will maximize your returns.
You will need to hire new people. Not just new people, the right new people, to do the job and that fit your culture. Hiring people is not an easy process and if it is not done right it can cost you valuable resources like capital and time.
A growing company needs increments in its infrastructure. It does not matter if the company is a manufacturing business or a service provider. A growing business needs, at the very least, more space for new personnel. Not having the proper infrastructure can also cost you valuable resources. On the other hand, you do not want to over increase the production capacity of your company.
Processes must be in place. Training is key when a growing business hires new personnel. It is natural that employee turnover will spike. Having proper processes in place will help you to mitigate the downside effects of a higher employee turnover.
Resolution 2: I will focus on business improvements that will drive my firm’s growth rate.
Owner Dependency
Owner dependency is a factor that quickly drives the value of a business down. The higher the owner dependency of a business, the harder it is to sell. Business knowledge and skills must be spread across key staff members for the eventuality of the departure of the owner.
Ronen Shefer listed four main points to regarding owner dependency in the business world:
Business sustainability is very important – From a buyer's point of view, a business must survive long past the current owners' involvement in order for them to have adequate time to receive proper return on investment and a business that can achieve that quickly is worth more.
Additional Cash Flow – When buyers look to purchase a business, they will always try to estimate the free cash flow generated from the business each year. If the current owner is required to stay post transaction, it reduces the amount of cash flow available to the buyer each year and therefore will ultimately drive the value down.
More Potential Buyers – A business that can run independently of the owner tends to attract additional buyers because these types of opportunities will attract financial investors with no ties to the industry or necessary experience because neither might be necessary to receive a return on investment. Just like any other transaction, more potential buyers can drive the purchase price upward.
A Sign of a Good Management Team – A business which is not dependent on the owner(s) for operations or revenue is a great sign that a good management team exists and adequate systems are in place to run the business. Strategic buyers, those who are looking to buy a business in order to grow their own, tend to value management team capability very highly and will pay a premium for a business that can run effectively without an owner.
Resolution 3: I will work on the business, not in the business, so my firm can be a sustainable operation in my absence.
Industry Outlook
If you had come up with an idea to start an on-line business in 2000, most likely you would have had access to funds without much struggle. It was the time of the dotcom bubble. Everybody was anxious to invest in tech companies. Conversely, if you have a startup focused on the oil industry today, most likely you will not find many investors interested in funding your business.
“The more attractive your industry, the more valuable your business,” said Michael Porter, renowned professor from Harvard. He points out the main value drivers of an industry:
The amount of barriers of entry for an industry. The harder for a new competitor to enter an industry, the higher the value to be captured in a certain industry. Think about how difficult is to start a new aircraft manufacturer compared to starting a new restaurant.
The level of competition inside an industry. The higher the level of competition, the harder for a company to generate large amounts of profit.
The power of bargain for suppliers. Who dictates the commercial relationship? You or the supplier? If the power of bargain is low amongst suppliers, the higher your profits will be.
The power of bargain for your customers. How much sacrifice you must apply in order to keep your customers? Do you push products to your customers or your customers pull products from you? The more power of bargain your customers have, the lower your profits will be.
The threat of substitutes. Are you screening your industry for the changes in its business model? Are you screening for innovations that can upside down your industry? What is the capacity of innovation of your company?
Resolution 4: I will gain a solid understanding of my industry and so I can position my business in a way to provide above average profits.
Local and Regional Economic Status
Economy is not static, it is dynamic. Economy has a cycle. The value of your business will be tied to the different stages of the economic cycle, as INC Magazinestates:
Recession: also sometimes referred to as a trough—is a period of reduced economic activity in which levels of buying, selling, production, and employment typically diminish. This is the most unwelcome stage of the business cycle for business owners and consumers alike. A particularly severe recession is known as a depression.
Recovery: Also known as an upturn, the recovery stage of the business cycle is the point at which the economy "troughs" out and starts working its way up to better financial footing.
Growth: Economic growth is in essence a period of sustained expansion. Hallmarks of this part of the business cycle include increased consumer confidence, which translates into higher levels of business activity. Because the economy tends to operate at or near full capacity during periods of prosperity, growth periods are generally accompanied by inflationary pressures.
Decline: Also referred to as a contraction or downturn, a decline basically marks the end of the period of growth in the business cycle. Declines are characterized by decreased levels of consumer purchases (especially of durable goods) and, subsequently, reduced production by businesses.
The last factor relies on timing. Knowing how each economy cycle stage affects the value of your business will help you to find the right time to sell or to implement an alternative transition strategy.
Resolution 5: I will determine the best point of the economic cycle to execute my transition strategy.
Summary
Leveraging the five factors that affect the value of your business will maximize the value you will be able to reap from your company. It is not an easy task to align your organization with all five factors at the same time. However, if you are able to accomplish this you can be assured to capture the highest possible value for your business.