Are you afraid of flying?
If you are, it won’t matter what the pilot says to reassure you about safety as your perception of the risk involved in flying is quite high. The pilot’s perception is going to be completely different.
When approaching a business with the idea of buying it, buyers will look at various factors and perceive certain risks to be higher than what the seller does. At the same time, the seller may see some risks on the horizon the buyer isn’t privy to.
When you buy a business, you’re really buying the business’ future profits, or at the very least, something that will one day show a profit.
Everyone has their own ideas around what kind of return-on-investment (ROI) they want to achieve. If a company is sold for a multiple of three to four times their profit, this implies that the buyer will expect their money back in three to four years.
So, what factors influence the final business valuation? We have all heard the expression, ‘the higher the risk, the higher the reward’. This is also true when buying businesses. The more risk the buyer sees in your business, the higher the return they will want, and in turn the faster they will want their money paid back. Therefore, the business valuation multiple may drop from a 3-4 down to a 2-3.
When it comes to valuation, business owners will often overlook many of the risks in their business. They’re so used to running it, that they have a certain level of comfort around the risks, and in many cases, they don’t even see them as risks anymore. But this doesn’t mean it won’t impact them when going through the process of selling a business.
Two things an owner should do to improve their business valuation if they are considering a business sale:
Look at your business through the eyes of a buyer
A seller needs to take off their “seller’s hat” and put on the “buyer’s hat” (and vice-versa). Look at your business from an external perspective, which includes the risk factors they’ll be thinking about. Buyers will rarely want to acquire a business to simply achieve what the previous owner was doing. They will be thinking:
- How big is the market?
- What’s the growth potential?
- Can we scale this business?
Along with considering the business growth opportunities, the business buyer will also be assessing the risks. In simple terms, they want to know if there is any risk that the business will not be able to produce the same revenue and profits that it has achieved historically. But also, what risks may inhibit the business from delivering on its potential.
One of the key risks is owner dependence. Is this business reliant on the owner to keep weaving their magic to make money? Is there special IP locked up in their head? Is it reliant on them having amazing personal relationships with their clients? What is the dependence on that owner?
One of the great assertions in business is that if you want to build a successful business, that you should get to know your customers really well. This usually involves the owner taking a personal interest, knowing all their customers by first name, and being accessible should a problem need solving.
However, data from nearly 60,000 companies presents an interesting paradox when it comes to building a valuable company. It shows that in companies where the owner doesn’t know their customers personally, and rarely gets involved in serving an individual customer, are getting offers 55% higher than those where the owner knows each of their customers by first name.
This runs completely at odds to conventional thinking, but when examined does make a lot of sense. The business is not dependent on the owner, meaning it has good people, systems and processes to handle sales and operations. This allows much greater freedom for the owner, but it also provides more certainty around the business’s ability to generate revenue and profits into the future.
Don’t put all your eggs in one basket
This paradigm never ages when it comes to managing risk, and it applies to a number of areas of your business.
Take Rick Day as an example. Rick built Daycom Systems into a $26 million dollar business over 17 years. While successful in many ways, Daycom had become over reliant on one supplier who was linked to around 75% of their revenue. Clearly, if something happened to this supplier, it could critically injure Daycom and the buyers were all too aware of this risk.
Rick still managed to sell Daycom Systems, but he received a lower offer to compensate for this risk. But it wasn’t just the reduced amount, there were also other terms the buyer imposed, which included an earn-out. Meaning some of the purchase price was dependent on the business hitting certain performance criteria. Unfortunately, in Rick’s case, he did not get all of the earn-out either, which further impacted his final business valuation.
In a similar fashion to suppliers, you need to consider how much revenue your largest customer contributes. Best practice is to keep this below 15% of total revenue. If it gets as high as 25% there are already some red flags for buyers, and of course if you hit 50% or higher, there are alarm bells going off.
This isn’t to say you can’t sell your business, but buyers will attribute a much higher risk factor which drags down the purchase price.
Concentration risk across suppliers, customers and employees is always going to be a significant factor in business sales and acquisitions.
Looking at your business from a buyer’s perspective is going to provide you with an alternative view on risk and valuation. Just imagine that you are looking at your business for the first time, and consider what factors would cause you concern. Whether you want to sell your business or not, addressing these risk factors will increase the value of your company, but it will likely make it more profitable, and more enjoyable to run.