Business valuations – part 3

July 24, 2017

In the last post, I talked about the selection of the “multiple” in the relatively simply formula for valuing a privately owned business:

Business value = Profit x Multiple

The multiple broadly represents growth and risk.

So what are the risk factors and how do they impact the selection of the multiple?

Pretend you are buying a business. You want a bargain. The history of profit is pretty clear and objective. The risk is the part you can poke around a bit and see what breaks.

The higher the risk, the lower the multiple and the lower the price you have to pay.

I have categorised business risk into eight areas with my thoughts on what represents a low risk business.

Risk Low risk business
Reliance on owner
  •  Documented succession plans
  • Investment in external management
  • Owner seeks business mentoring
  • Spend no / little time on the tools
  • Focus on strategic and investment decisions only
  • Takes regular time off
Defined business systems and procedures
  • Documented and well organised
  • Buyer has confidence that they can run the business
  • Copies of leases, contracts, software licences and so on
  • Accessible and shared with staff
  • Useful CRM in place
  • Clear ownership structure (avoid messy trust structures)
Staff and management team
  • Low staff turnover
  • Managers able to make operating, financial and investment decisions
  • Regular training and mentoring
  • Accountable for the good and the bad
  • External help is often sought
  • Clear reporting structure
  • OHS is well managed
  • Incentivised to share in growth
  • Employment agreements in place
Diverse and repetitive
  • Customers are repeat, recurring, diverse and contracted
  • Suppliers are abundant and not price makers
  • Products are diverse and / or unique
  • No single customer / supplier represents more than 10%
Asset quality
  • Current register of assets
  • Suitable maintenance records
  • Regular replacement of core assets
  • Legal protection for trademarks, products, patents
  • Excess equipment is sold – if not needed, get rid of it
  • Mix of ownership and leasing of assets
  • Environmental audit undertaken
  • Understanding of intangible value in business
Financial discipline
  • Up to date records that are reliable
  • Audited financials
  • Integrated system with low human involvement
  • Qualified finance team
  • Regular review of performance
  • Budgeting at least annually
  • Decrease working capital investment
  • Maintain employment provisions and keep in balance
  • Staff take leave
  • Adequate insurance in place
Clearly defined plans
  • Strategic plan exists and is used
  • Business plan supports strategic plan
  • Plans reviewed regularly
  • Plans are realistic, not nonsense big hairy goals
  • Plans shared with others in the business
Optimise capital structure
  • Right balance of debt (cheap) and equity (expensive)
  • Tax deductible debt used to fund growth
  • Investment risk spread across owners and lenders
  • Debt is consolidated
  • Low reliance on short term funding like overdrafts
  • Cash is returned to owners when not re-invested

A business owner can achieve a significantly higher business value when controllable risk has been identified and a plan of attack is underway to manage these risks.

To paraphrase the irreverent Mark Twain, a successful business is not made of what is in it, but what is left out of it.

Reducing controllable risk is often a lot easier than doubling your sales or your profits.

Next time we will talk more about the illusionary EBITDA…

Lachie McColl