Many business owners understand the importance of knowing the value of their company. Unfortunately, many do not appreciate that an independent business valuation identifies the key risks facing the business that affect and determine an appropriate valuation multiple.
The valuation of your business is integral to wealth management, tax/succession planning, a potential sale and dispute resolution. A thorough assessment is, therefore, required to consider the factors that impact your company’s valuation multiple.
What is a Valuation Multiple?
Value for most operating companies is a function of the present value of the future annual cash flow stream (e.g. net income, EBITDA, etc.) that the business will generate going forward. In order to convert this future cash flow stream into a lump sum present value, the annual cash flows or earnings are multiplied by an appropriate “valuation multiple”.
The valuation multiple is a function of the risk facing the business and is the inverse of the rate of return required by potential purchasers for the business. Simply put, increasing the risk associated with the business will decrease the multiple a potential purchaser would be willing to pay for the business. Conversely, decreasing the risk associated with your future earnings will increase the multiple an investor would be willing to pay for your business.
Understanding the major factors that increase and decrease your company’s valuation multiple allows business owners to focus on specific areas that will help maximize value. Below are some of the more important factors that increase and decrease your company’s valuation multiple.
Factors that Increase the Valuation Multiple
Loyal Recurring Customer Base
A loyal and recurring customer base implies a regular flow of operations and consistent income. This is beneficial to the company’s valuation as it reduces the risk associated with future revenue generation. Having long-term contracts with customers or a renewable subscription based revenue business will help to further maximize your company’s valuation multiple.
Strong Management Team and Engaged Workforce
A strong management team and engaged workforce are extremely difficult to find and even harder to motivate and retain. A management team with deep bench strength can accomplish much more than a company that is dependent on its sole owner and is much more attractive to a potential purchaser. It’s no surprise that companies with this attribute command a higher valuation multiple in the marketplace.
Growth
Potential purchasers are attracted to companies that are scalable and have high growth potential. Future growth implies increased revenues and annual earnings. A plan for future growth will help to increase your valuation multiple but demonstrated historical growth with a clear plan for future growth will have a greater positive impact on your valuation multiple.
Reduced Risks
Any other factor that helps reduce your company’s risk profile will help increase your valuation multiple. This can include your company’s competitive advantage, brand reputation, level of company debt or how diversified the customer base is.
Factors that Lower the Valuation Multiple
Reliance on key Customers and Suppliers
When business operations are overly dependent on key customers or suppliers this increases the risk associated with the business. For example, if one customer makes up more than 80% of the company’s revenues, the future earnings stream will be contingent on their purchases. Similarly, if a significant portion of your purchases are from one key supplier, what happens if that supplier decides to raise prices or is not able to supply the volumes you require? The risk associated with your company’s future cash flows increases significantly and your valuation multiple decreases accordingly.
Dependence on Owner and Personal Goodwill
If your business is overly dependent on the business owner’s personal skills, abilities and contacts in the industry, the transferability of your customers and future cash flow stream to new owners becomes questionable. This “personal goodwill” is not commercially transferrable and will significantly reduce the valuation multiple that a potential purchaser would be willing to pay for your business.
Volatility in Earnings
Volatility creates uncertainty and uncertainty increases risk. If your company’s net income fluctuates over time, potential purchasers will apply a lower valuation multiple to your business than if earnings have been stable or increasing over time.