What is driving the value of your business?

In this article I will discuss the drivers that influence the value of your business. Business value is critical when it comes time to sell up, but you need to start thinking about maximising that value long before you decide it's time to sell, if you want to get the best possible price.

Let's take a look at some of the influences on the price or value of businesses and then see what can be done to magnify their effects.

Demand vs Supply

An obvious influence on the price is the basic economic equation of demand v supply. If your business is unique and performing well, it will have a much greater chance of attracting a higher value, given an equal demand level of potential buyers. One of the major factors that will affect business values over the next few years is the baby-boomer factor.

Currently across the world, the average age of business owners is increasing due to the fact that the majority are owned by people of the baby-boomer generation. The issue here is that most of these owners will be looking to sell or move on from their businesses over the next 10 years or so. This will create a large bubble of increased supply, which will mean that potential buyers will have a much greater number of choices.

This increased supply will drive the market down over all. Average businesses will become very hard to sell and many may not attract a reasonable price at all. This situation could be severely demoralising if you have spent 20 or 30 years building the business and expecting it to be worth a lot when it comes time to retire. The challenge is to create a business that is highly sought after in a difficult market, rather than simply build a business that looks like most other businesses on the market.

Earning Power v Risk

There are a number of ways to value a business, but the most predominant method is based on the earning power of the business. Rather than simply calculate the capital value of the physical assets owned by the business, less the value of the liabilities, which would be how the value appears on the company balance sheet, a business valuation based on its earning power is more relevant to most investors.

Investors are typically looking for a high ROI (return on investment) that is greater than they can get from investing their money in other asset classses. For example, simply putting money in the bank may earn up to 9% or 10% interest per annum, depending on current underlying interest rates. This is regarded as a reasonable low risk investment. Investing in a business is a much greater risk, therefore, the ROI required is much more. Therefore, the ability of the business to consistently earn an income that will give an acceptable ROI to an investor is critical. The higher the risk, the greater the ROI required, therefore the lower the valuation your company will achieve, relative to it's average earning power.

Earning power is typically related to earnings before interest and taxes (EBIT). The typical business valuation method is to derive a value based on a multiple of EBIT, the multiplier being related to the level of risk and reliability of achieving that EBIT. For example, if your business has made consistent profits of $200,000 over the last few years, a multiplier of 3 would value your business at $600,000. In some industries there is a typical multiplier used which is based on the typical profile of a business in that industry. However, you can get your business valued at a different multiplier if it has some unique characteristics that make the standard multiplier irrelevant in your situation. There are a number of factors that can influence the multiplier.

Consistency of Profits (EBIT)

Reliability of performance will increase the multiplier used to value the business. This is a two edged sword. The basic variable used here is EBIT, so naturally, the higher your average profit levels, the greater the value your company will achieve. However, if the variability of EBIT is high over the years, the multiplier will be lower, due to the inherent risk factor of achieving the level of EBIT required to provide a desired ROI. A consistent level of EBIT will attract a higher multiplier.

A business with low and variable profits may only achieve a valuation of 2 times EBIT, while a consistently high performer may attract a multiplier of 5 or more, given other assisting factors.

Owner Dependency

Another major factor in the valuation multiplier is the level of dependency the business has on the owner. If a business has its value tied up in the relationships the owner has with customers and/or suppliers, the multiplier will be lower than if the business' performance is totally independent of input from the owner. A business that is not owner-dependent can be a very attractive investment for an investor who has limited experience in the particular industry of the business.

Market Strength

Does the business operate in a market that is growing and likely to continue growing for some time? Or is the market for the company's products mature and demand decreasing? These factors will influence the EBIT multiplier. A company with a new product in a high growth market will be a much more attractive to a buyer than a run down, tired operation that has an aging product line.

People and Skills

How knowledgeable and skilful are the people on the team and how committed will they be to the business after the new owners are on board? If you can create a business that has a strong, committed team, your business will be much more valuable and attractive to an investor.

Brands and Intellectual Property

Does your business have unique brands and trade mark protected products? These factors enhance the uniqueness of your business and make it more valuable.

Does your business have proprietary processes that provide a distinct competitive advantages? Having systems and processes that are difficult or impossible for others to copy greatly enhances the value of your business and increases the multiplier.

Revenue Streams and Distribution Channels

How many ways does your business make money? If you have a single source of income, the risk associated with your business is much higher than if you have multiple streams of income.

Developing a number of different product lines or service categories will provide greater stability for your income and reduce the risk in EBIT variability, therefore creating a higher multiplier of valuation. In the same way, having multiple distribution methods will reduce the risk of volatility in your income generation and create increased business value.

How to Increase the Value of Your Business

The time most people start to think about the value of their business is when they start to think about selling it. This is far too late, if the thoughts of selling relate to a short time frame. It takes time to build value and it is something you should be focusing on from the inception of your business. When you are developing your business strategies is the time to think about how to increase business value.

If all you do is focus on the day-to-day, week-to-week, or month-to-month performance, you are likely to be neglecting the issue of increasing value. All of the value influences listed above take time to develop and are not likely to happen by accident. They come as a result of developing specific plans to do what it takes to make it happen in these areas.

Right now you need to see what you want your business to look like when it comes time to sell and decide what price you want to sell it for at the time. Then you can start to take the steps to build the value drivers and create the brands, the systems and the structures that will influence the value when you are ready to move on.

Don't be like most business owners and leave this to chance. You are great at making your products or crafting sales. Take the time to plan your business development and how to fashion your business into the desirable, attractive investment option it can become. The comfort and enjoyment of your retirement depends on it.

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