Exploring the factors that drive business value
Most experienced business leaders recognize the importance of staying on top of financial data, and how critical financial performance is to the value of a business. However, knowing exactly what numbers to look at and what stories the trends tell is not always easy. A previous article in this Control Engineering series focused on financial indicators and how to use these to increase value. Other factors also play a key role in increasing value in a business including:
- The growth potential of a business
- Dependency issues the business may have with customers, employees, or vendors
- The health of a company’s cash flows
- The recurring nature of revenues
- The size of the business’s market share
- How satisfied the customers are
- Dependency issues on the business owner.
This value driver helps identify the likelihood that the business will grow in the future, and at what rate. Here are a few questions to use to assess growth potential:
- What is the industry outlook for growth? Can the company meet or beat these expectations?
- If the industry is stagnant or in decline, are there adjacent services I could offer my customers, or a way to package my services for a new group of customers in a similar industry?
- Do my culture and processes support a growth mindset?
- Can I grow by increasing prices? Will my customers remain interested in my products or services at that price point?
- Would investing in my staff with sales training be beneficial to increasing sales? It can be worthwhile to provide sales training to all staff who "touch" the customer, not just the sales staff.
This value driver covers dependency issues relating to any one employee, customer, or supplier. If any relationships ended within these categories of people, would the company encounter significant hardship?
Here are some considerations to ensure business relationships are all in balance:
- Avoid customer dependency: While strong, long-term relationships are certainly a good thing, if any one customer represents more than 10% of total revenues, or more than 30% of total revenues are generated from the top five customers, this represents risk to a business owner, and raises a red flag to any buyer. While no one wants to decrease revenues to any one customer, it will drive value if new customers are added or revenue can be gained from other existing customers.
- Avoid employee dependency: Cross train employees and document processes to avoid the risk of "tribal knowledge" among small groups of employees.
- Avoid supplier dependency: Identify back-up suppliers, or maybe complementary vendors so you are purchasing from more than one key vendor.
Valuation teeter totter
This value driver considers whether the business is more of a cash suck or a cash spigot. There may be different answers for different parts of the business, and it’s useful to identify the answer for various segments, as well as the whole, to understand how a product or service mix contributes to the whole picture including:
- Do you know cash flows from operations? Do you know your cash flows from operations after reinvesting in necessary capital expenditures? If not, ensure the accountant is communicating this information regularly. Cash is king.
- Can you structure payments differently from clients to get cash more quickly? Can you collect a deposit at the beginning of the project that is applied to the final invoice?
- Develop a relationship with a bank before you need banking services. Community banks tend to focus on the business owner and the story of the business as a means to develop long-term relationships. Lowest interest rate isn’t always the best choice. Will the banker stick by you in the downturns as well as the upturns? Are they interested in learning about the business and developing a long-term relationship?
- Can you increase the length of time you have to pay vendors? Would entering a contract to define a longer relationship benefit you with better payment terms?
- You don’t have to bill monthly—bill weekly. Offer a small discount for payments received within 7 or 10 days instead of having to wait 30+ days for payment.
This driver considers the proportion and quality of automatic, annuity- based revenue that is collected every month. Buyers like to see a steady stream of income from reliable sources. Here are questions to ask:
- Even if the business is bid- or contract-based, can you provide warranty or maintenance services that allow you to continue to follow up with the customer regularly throughout the year?
- How can the firm be a resource for customers beyond traditional project-by-project engagements?
- Is there a way to make any part of the business a "subscription" or a retainer-type of business? In other words, can you structure sales, for maintenance work, where the annual cost is invoiced on a regular, monthly payment arrangement instead of only charging when a service is provided?
- If a service is provided, can you generate a troubleshooting service where the company is paid each month to address problems?
- Is there a consumable product or supply to create or resell that requires re-purchase?
- Is there some sort of analysis, reporting, or other feedback to offer to add value to clients? Can this be an automated service each month?
Having the majority of market share within your geographical location or industry niche is an ideal situation, so it’s important to be able to answer the following questions:
- Why does the company exist?
- How can you deliver on customer needs better than competitors?
- Do employees clearly understand the "why" and "how" so they can consistently deliver on these fundamental messages in communications and through client deliverables?
Customer satisfaction may sound like an obvious driver, but not all businesses have processes and procedures in place to capture feedback. This is important to either do more of what is working well or fix issues to avoid repeating the same mistakes in the future. Here are a few questions that can help put those procedures in place:
- Do you have a consistent and measurable way to get feedback from clients? An important question to ask all clients is "how likely are you to hire our firm again, or refer us to another contact?" When customers won’t provide feedback, it is typically because the format of it takes too long or it is too much of a distraction from day-to-day business. Keep it simple.
- Do you, or the team, promptly and completely address any customer issues?
- Do employees know your philosophies on how to handle situations that are not going as the client expected or hoped?
- How do you take undesirable situations and make them positive learning opportunities?
- Are you able to turn satisfied clients into referral sources for the business?
Hub and spoke
A business that is too reliant on the owner to run the company can be less valuable to a buyer. While the owner often plays a critical leadership role, to be transferable, a business must be able to continue operations without the owner for an extended period. Consider these questions and factors to evaluate how dependent the business is on the owner:
- If the business owner was absent for more than month, would the business still have the ability to continue?
- Does the staff have the technical and business expertise to continue serving existing clients while also continuing business development efforts?
- Is there a succession plan and are the right players in place to deliver that plan, if needed?
- Is the right team in place that allows you to delegate without major concern?
- Document systems, procedures, and history.
These questions and factors should provide a much deeper understanding of how to drive value to the business. Savvy buyers will be looking at these factors because they know they impact value. Whether you plan to sell in the near future or want to build value for your continued ownership, these questions will be helpful tools to review yourself or with your leadership team quarterly and annually.
Whichever approach you take, it is important to set goals and KPIs, or key performance indicators, for each driver so you know what success will look like.
Catherine J. Durham is accredited senior analyst, principal, and president, Capital Valuation Group; edited by Emily Guenther, associate content manager, Control Engineering, CFE Media, email@example.com.
Factors that drive value to a business.
Understanding ways to improve business value.
Identifying how buyers evaluate business value.
Should certain industries be more concerned with particular value drivers than others?
Coming soon: A link to part 8 in the Business Valuation Article Series will be offered below.