There is a common misconception amongst entrepreneurs that the valuation of their company for whatever reason by experts in the field equates to the saleability of their company and the approximate value it is worth. Total myth.
Valuation
The American Institute of Certified Public Accountants (AICPA) sets out in summary the valuation methodology to adopt depending on the six stages of your company. It categorizes as follows:
Stage 1: No product revenue.Incomplete management team. Some seed Funding. An idea and maybe some product development. Valuation method – Asset approach.
Stage 2: No product revenue but lots of expenses. Second round of funding in place. Product development started. Valuation method – Investments made by VC firms and a DCF with high discount factor!
Stage 3: No revenue but product is beta testing. – Valuation method – same as Stage 2.
Stage 4: Generating revenue but loss making. Mezzanine financing. Valuation method – same as Stage 3.
Stage 5: Breakeven or positive cash flows. IPO or sale is a possibility. Valuation method – Income and market approaches.
Stage 6: Established profitable company. valuation method – Sames as Stage 5.
If this is the kind of advice coming out of Institutes, is it any wonder that there is a huge discrepancy between “Valuations” and how an acquirer assesses a target. It’s nonsense.
Going beyond this generic guidance most CPA firms and Valuation Consultants will consider the following criteria to establish a “Fair value”:
- Discussions with management regarding the history and future of the company.
- Historical financials and future projections of Profits and Cash including management presentations, business plans and Shareholder Agreements.
- Balance Sheet Net Assets.
- Public company values and the Price Earnings ratios implied by that value.
- Previous transactions and the values paid.
- Economic outlook of your sector.
- Discounts related to lack of marketability of the shares (can’t trade on a stock market).
This research will lead to a valuation based on:
- A multiple of profits
- A multiple of Revenue
- The Net Assets
- An estimate of Net Present Value of future free cash flows (operating cash generated after Capex before funding costs)
A valuation range will be assessed and you are done! And let’s say that is $12m to $15m.
And these are important items to review however don’t think for a minute your business is firstly saleable or worth $12m to a buyer.A serial successful acquirer has a unique lens and entrepreneurs need to understand that viewpoint if they are to scale a business to a liquidity event at a exceptional value.
Saleability, How Buyers Think, Value creation
The essence of the M&A game regarding value is quite simple.
Sellers aspire to price. Buyers perceive value.
Yes a buyer will take into account points 1 to 7 above but a buyer is perceiving value. A buyer is considering post-acquisition strategic fit of owning your business. The saleability of a business is driven over time by executing Value Creation strategies. Being exit ready has more to do with addressing the risks you pose to a buyer. Any company can obtain a valuation but that doesn’t make it saleable. Most years in the US around 8000 companies sell out for $10m or more. In context there are approximately 6 million US companies that run a payroll.
How does a buyer think?
A serial acquirer understands that it is irrelevant whether a company is up for sale. They understand that the key is to buy what you want to buy. An acquisition is a tool to enable the execution of a strategy. The more precise an acquirer defines the target criteria then the more likely the acquirer research will uncover appropriate targets to assess.
How does this affect a seller’s growth strategy? Well most entrepreneurs have a tendency to get distracted (shocker). They possess boundless energy and ideas but often lack the discipline to stay focused. They launch weakly conceived new products. Diversify into areas that dilute the brand. Instead of becoming remarkable at one thing. For example 37signals is remarkable at Project Management, and Wasabi is remarkable at cloud storage. There are many examples of focused private and public companies where their success was built on a myopic focus on one superpower to change people’s lives.
Understanding how acquiers think is vital to scaling a private company to create value even if you never sell it.
Why? Because it allows management to scale a safer company.
At The Portfolio Partnership we’ve been building our Saleability Test™ for over 30 years, developed from our knowledge as Investment Bankers turned operators! This test gives owners insights into creating value over time. It highlights priorities that need executed over the next 2 years to be exit ready. It pinpoints what acquirers cherish. Think of it as a series of questions to confirm you are exit ready.
This is how buyers think. These are risk factors buyers are considering under their ownership.
Assessing your company in this manner is life changing. Our work with entrepreneurs alongside our partners at The Grist is transforming their priorities. By assessing saleability alongside a deep review of branding and competition we are able to build a holistic view today of a buyers assessment.
The big issues that this checklist covers include Positioning, Dependency, Growth, Relative size of EBITDA, Visibility of Revenue, Market Growth, Staff Engagement, Management Quality, Legal Risks, Operational Excellence. very few of these are covered in a Valuation!
Buyers are using this checklist to perceive the value of owning your business.
You can now imagine why companies aren’t saleable. They are just not ready for primetime.
Most companies that come to market don’t sell. Those that do, the owners are often disappointed with the outcome. The current exit process is deeply flawed. Sellers are looking at Valuations instead of Saleability.
Good News – Deploying Value Creation Tactics Works
Almost all private companies no matter the size (by the way 6.1 million out of 6.2 million employ less than 100 people, could transform their value and saleability by focusing on Value Creation Strategies. We are talking about measured strategies over time that can improve your Saleability Score and to create rarity value through the lens of investors/acquirers.
This is the new framework – building a business through the lens of a buyer instead of the lens of a seller. Let’s take each test score potential one at a time, reviewing all 15 to inspire you to reimagine how to scale your business.
- Assessing your brand and positioning in the marketplace relative to competitors, relative to customers and relative to acquirers is essential. Is your positioning confusing? Is your website still talking about speeds and feeds? This is why we partner with the award winning agency, The Grist – who have been repositioning and building world class brands for over 20 years. Take control of your brand. Simplify your value to prospects. Positioning and branding are a country mile above all other playbooks. If you don’t know who you are, why do you have the audacity to hire anyone, launch products and engage with customers?
- Dependency is a deal breaker for acquirers. Dependency on one person the owner is way too risky for most acquirers and I know there are exceptions say in the AI space, but across almost all sectors its a turn off. And certainly lets say the business is dependent on Frank the owner to build the code or Francis the owner to win all the business, the acquirer will structure the deal around an earn-out with limited cash at completion. The owner could be locked in for 3 years. Build succession planning into every role. It takes time but its a safer way to scale a business.
- Size matters. Businesses producing less than $1m EBITDA rarely move the dial for acquirers. Interrogate your margins. Optimize your organization to deliver more for less. Once you burst through the $1m EBITDA level you are making the business safer. Below that, one bad hit could jeopardize liquidity. And certainly the higher the EBITDA, the higher the multiple acquirers pay if top line revenue is growing.
- Could a start up steal your lunch? What makes your product/service defensible? Do you have IP protection? Do you a have strong competitive value proposition. This might be as simple as offering a highly engineered manufactured configured product at a competitive price in half the time of the competitors. What are your superpowers that offer a unique offering? What could you do over the next few years to build a competitive moat around your offerings?
- Acquirers don’t want to buy a problem. If your revenue is flat or slowing down and assuming your fixed costs are fixed, the trajectory of profits looks weak. Is there a systemic problem with your market, with your products? Growth shows the outside world you have a solution people need and will pay for.
- Dependency on a few customers is risky. Gold standard is that no one customer accounts for more than 25% of revenue. Ideally the top 10 customers account for less than 50% of revenue. This is more difficult to achieve is a narrow, technical sector for example like highly technical production equipment where they may be only 10 to 20 global buyers of the product.
- Are you in a market segment that’s growing? Does your product road map address your industries future needs? Even in more mature industries like printing and packaging, it is possible to find a niche growth area worth capturing.
- An acquirer is always looking at the potential of your business. If your products are 10 plus years old, then the acquirer will be concerned about the number of years of sustainable revenue streams. Has your business become a cash cow reliant on a limited future?
- Do you have a broad bench of leadership talent? There is a popular misconception that all acquirer’s have a warehouse full of super clever operators just waiting to run the next target acquisition. Total myth. Acquirers need talent and specifically great operators that run things and make money.
- Are your staff engaged? Dan Pink authored a great book in 2011 called Drive – The Surprising Truth About What Motivates Us. The essence of motivation around coming to work can be divided into three camps (assuming your wages covers your basic cost of living). Autonomy – let me do my own thing at work, don’t micromanage me but don’t leave me alone all the time either. Mastery – help me be the best I can be at my job. Purpose – give me a higher calling that confirms that the work I do matters. Use training, documented playbooks, clear organization structures and consistent communication to drive alignment and motivation amongst your staff.
- We live in a world where technology is everywhere. Some larger groups have over 100 software tools purchased originally to handle sales and marketing tasks but many have never been used! What is the purpose of your technology stack? How does it integrate with each other? Even with legacy systems it’s now possible to create insightful dashboards by introducing a Business Intelligence (BI) layer to extract data farms and present dynamic info that be used.
- How can you make your customer relationships stickier? Certainly the SaaS model and various subscription models talk to a future sustainable stream of revenue which is a very attractive trait for investors and acquirers. However you may be in the construction or manufacturing sectors where it’s not possible to have a SaaS model. But instead you could have a quality backlog, maintenance agreements and longer term contract deals in place which talk to the same topic – visibility of revenue.
- Is your Balance Sheet in good shape? Are you maximizing your working capital ratios? Is inventory tightly managed? Are you auditing your Capex investments? Do you measure free cash flow and execute improvement programs?.Is it time to consider a recapitalization? Are your accounting policies in line with GAAP and/or industry standards?
- Do you have lingering litigation issues? Whether it’s employee related, product related or customer related the key is get these settled long before an exit process. Don’t give acquirers the opportunity to use a relatively small litigation issue as a bargaining chip.
- Playbooks describing how you do things around here serve many purposes. They allow constant improvement driving optimization of a protocol. Sales, Marketing, Finance, Production, Software Development, Customer Onboarding. There are no industries where playbooks don’t work. It forces alignment between departments, it builds clarity amongst employees of what is expected of them and it allows fast onboarding of new employees.
Summary
These are the frameworks to build valuable businesses. It’s never too early to consider the exit as you scale your business even if you never sell out. This is a safer way to scale your business because it aligns all teams, all departments, all efforts around a positioning you can dominate. It confirms you are building products that improve the life of a customer at a margin that is sustainable. A valuation of a business is often a two dimensional analysis which omits how acquirers think and specifically how they perceive value from target companies. Instead establish Value Creation strategies that address your priorities and build a business that allows you to have fun and make money.
More information can be found on our website The Portfolio Partnership.
Ian@TPPBoston.com
