This article deals with another aspect of Step 3 of our firm’s six step planning process for helping business owners create an optimum succession plan for their business and exit plan for themselves which best meets their business and personal objectives. To recap:
Step 1: Help the business owner identify his/her life objectives including retirement income, manner of disposition of the business, and non-economic life objectives which add significance to the owner’s life;
Step 2: Determine where the owner (and business) is now and what the gap is in terms of meeting the owner’s economic retirement objectives; and
Step 3: Determine what steps the owner should consider to fill the gap by increasing the value (and selling price) of the business.
When it comes down to your business, a buyer only cares about two things: Return and Risk. How much profitability will your company make in the future (Return)? How reliable are your estimates of future profitability (Risk)?
In its simplest terms, Value = Return/Risk, where Return equals cash flow and Risk equals a buyer’s required return on investment. The Return is calculated as the EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of the business. The Return is normally easy to calculate (though don’t forget to consider addbacks, non-recurring revenue and expenses, etc.).
The Risk is dependent upon how reliable potential buyers of your business feel your estimates are as to your business’ future Return. If your future return is considered very risky, a buyer may require a 50 percent Return on his investment. If your estimates of future return are considered relatively safe, a buyer may only require a 10 percent Return.
Basically, the lower the Risk, the higher the multiple of cash flow you will receive upon sale. The multiple is the reciprocal of the required return. If the required return is 10 percent-, then the multiple equals approximately 10 (1/.10=10).
What all this means is that there are only 3 ways to increase the value of your business: 1. Increase Return; 2. Lower Risk; or better yet, 3. do both!
To increase Return and lower Risk, a business owner should employ “value drivers.” Value drivers are what qualified buyers look for in a business which increases the business’ value by increasing Return or lowering Risk. What are some of the key value drivers?
A Clear and Compelling Vision. This sets the expectations for employees and creates a common mission across the business, communicates culture and core values, and provides employees with significance from their job beyond a paycheck.
A Growth Strategy. A believable and executable plan to achieve the growth objectives within the vision. The more scalable your business is, the more likely a buyer will believe your projections since the business growth is not dependent on the owner.
A Stable and Motivated Management Team. A team capable of driving future success without the owner. These key employees should be tied to the company by carrots(incentive plans, possible ownership, stay bonus plans, etc.) and sticks (non-compete, non-solicitation of customers and employees agreements, etc.).
Products/Services. Includes vibrant, growing niche markets, proprietary or patented products or services, and contractual and re-occurring revenue streams.
A Diversified Customer Base. No one customer is larger than 15 percent of your revenue. Customers are financially healthy and have contracts with your company.
Excellent Operating Systems. Operating systems with the right operational performance metrics.
Fixed Assets. Facilities appearance and condition is excellent as well as the age and condition of operational assets.
Financial Systems and Effective Financial Controls. Financial reporting is accurate, timely and useful.
Financial Growth. Growth in all three areas of revenues, cash flow, and profitability at once.
Owner Removed. If possible, the owner is already removed from the business (one of the most important).
However, from our experience, the single most important value driver is your overall relational health with your employees, customers, suppliers, and co-owners. Always be respectful and kind to your employees and continuously recognize them for good performance. Make certain you are surveying your customers to ensure you are serving them to the best of your ability and you have no misunderstandings. (Try a tool called the “Net Promoter Score” as a proven and formal way to predict growth). Have great relationships with several separate suppliers. Work hard to keep your communications and understanding (as well as contracts) up to date with your co-owners.
Next month we will discuss a number of other ways to manage and lower your Risk that your cash flow will be interrupted or decreased.