What makes a company valuable?
Two companies with the same financial performance (same revenues, same earnings) can have wildly different valuations. Why?
Business valuation is ultimately determined by the value of all the estimated future cash flows a business will generate (plus the expected value of the company when it sells), discounted by what is called a “discount rate”. The discount rate is an estimate of how risky the company’s future cash flows are.
8 Factors That Determine How Much Your Company is Worth
Companies whose future cash flows are less predictable and perceived to be riskier will have a higher discount rate and a lower valuation compared to companies whose future cash flows are highly predictable and therefore less risky.
As a result, companies can increase their valuation by (i) increasing the expected future cash flows from your business (i.e., having a solid growth plan), and (ii) decreasing the level of perceived risk in your future cash flows. Higher expected growth and lower perceived risk will make your business more valuable.
Don’t rely on online business valuation calculators
There are hundreds of business valuation calculators on the web, but they can be dangerous. Business valuation calculators that do not critically assess your future growth plans or the level of risk in your cash flows will give you a false sense of certainty about what your business is worth.
Your best path is to find an investment banker or valuation expert who can account for these less quantifiable aspects of your business to tell you what your business is likely to sell for in the market. You don’t want to make important decisions based on a half-baked assessment.
8 factors that drive higher company valuations
1. Build (and execute) a solid growth plan.
Most business owners do not have a growth plan that would survive scrutiny from a professional investor. Defensible growth plans have support and analysis behind every driver of revenues, expenses, and capital investment over a 3-year forecast period (by month).
For example, good growth plans build sales up by salesperson over time to see if the assumptions going forward (sales per salesperson) are consistent with prior key performance indicators (KPIs). This is true for every line item of your income statement and balance sheet.
Unlike a mutual fund disclaimer, prior growth performance is a good indicator of expected future performance in the eyes of an investor. Companies might also choose to grow by acquisition – acquisitions are challenging, and companies with no prior experience completing a successful acquisition and integration will have a hard time convincing an investor that acquisitions will be a major component of your growth story.
2. Build a “moat” around your business.
Warren Buffett likes businesses that have competitive “moats” that protect them from competitors. How can you do this?
Several ways: products that are protected by patents or other intellectual property rights, exclusive distribution rights in a particular geography, long-term contracts with your customers, strong consumer brands, high barriers to entry for competitors, high switching costs for your customers, among others.
These take time to develop, so as you are building your business, focus on how you can better protect your revenues and customer relationships from competitors.
3. Build your management team.
We have had hundreds of companies use our risk assessment tool called CoPilot (free to users), and in more than 80% of those companies, the business is too dependent on the owner.
The owner might be responsible for overall operations, or responsible for most of the company’s sales or customer relationships, or is the creative mind behind product development. Having these critical operations of the business depends heavily on the owner simply means the company’s future cash flows could be significantly interrupted if something happens to the owner.
Building a deep, experienced, and proven management team not only creates more time for the owner to focus on the things they love to do (inside the business and outside the business), but it will also make the company much more valuable.
4. Build a strong track record of profitable revenue growth.
A long and strong track record of generating profitable revenue growth will decrease the perception of risk in your business.
If your revenues and profits are highly volatile over time, most investors will perceive significant risk in your business and therefore ascribe a lower value to it.
5. Diversify your revenue and lead sources.
More than 40% of our CoPilot users have more than 20% of their revenues coming from one customer or more than 50% of their revenues coming from just their top 5 customers. This creates significant risk in the company’s future cash flows.
If something happens to that customer or the company’s relationship with that customer, the company’s future cash flows could be significantly disrupted. The same is true for your lead sources – if your company gets most of its leads for new business from a single source, losing that lead course will also be highly detrimental to your company’s future cash flows.
Build your business so that no more than 5-10% of your revenues come from any customer or lead source and your business will become less risky and more valuable.
6. Drive greater predictability in your revenues.
Companies that cannot predict what their revenues will be for the next month or next quarter have much more risk than a business that has its revenues locked in for several years. This is one reason why software-as-a-service businesses are valued so highly – their future revenues are much more predictable, decreasing perceived risk.
If you are able to build repeat or recurring revenue streams from your customers that are highly predictable going into the future, your business will be more valuable.
7. Clean up your books and records.
This seems to be unrelated to profits and revenue growth, but when dealing with professional investors, first impressions are important.
If your books and records are a mess and hard to navigate, investors will perceive that the rest of your business is also operated in a sloppy way, increasing their perception of risk in your business and decreasing its value.
Having a great first impression by having contracts organized, clean corporate records and easily accessible financial information will lead investors to believe you have your act together and run a tight ship. This will increase your company’s overall valuation.
8. Implement strong financial controls.
More than 80% of our CoPilot users have inadequate financial controls. Owners are not reviewing their vendor or customer lists regularly, customer payments are not coming to a lockbox, too many people have access to critical bank records and accounts, financial statements are not audited, or the owner is not reviewing their cash reconciliations monthly.
Putting strong financial controls in place not only protects you from fraud, but it also portrays the image of a well-run business to an investor, decreasing their perception of risk in your business and increasing value.
What if you never want to sell your company – does company value matter?
Some business owners do not plan to sell their companies. They want to transfer the business to their children, management team, or maybe an ESOP (Employee Stock Ownership Plan). Should they focus on increasing the value of their business with the 8 steps outlined above? Absolutely.
Business owners who decrease the level of risk in their business not only increase the value of their business but also make the business more predictable for themselves, reducing their anxiety and allowing them to sleep better at night.
They also make the business much less risky for their children or employees, making it more likely they will succeed once they take over the operations of the business.
There is probably no worse feeling for an owner of a business than to see their creation fail in the hands of their kids or employees.
So, spending time on these initiatives to make the business less risky will dramatically reduce the odds of a failed business once it has been transitioned to their kids or employees.
About Chris: Chris Younger is the Co-Founder and Managing Director for Class VI Partners, a financial services firm focused exclusively on business owners. Chris spent more than 20 years gaining experience in executive management, marketing, sales, law, and mergers and acquisitions. Chris was a co-founder and President of Expanets, the nation’s largest provider of converged communications solutions. Prior to Expanets, Chris was an associate with the law firm of Wilson, Sonsini, Goodrich, and Rosati, and clerked for the Honorable Jesse Eschbach of the U.S Court of Appeals, Seventh Circuit.
