Well worth it: Building business value

The future is now. While this may be an overused quote, it certainly applies to the succession of Canada’s private businesses.

By Suzanne Loomer, CA

According to a BDO Dunwoody LLP/COMPAS Inc. survey of small- and mid-size business owners, 71 per cent intend to sell their businesses within the decade.* Hundreds of thousands of baby boomer owners of Canada’s mid-market businesses may be looking for successors or buyers — all at the same time.

Given that it can take several years to prepare a company for a smooth succession or sale, the future is definitely here.

If a sale or succession might be a possibility in the next few years, a management team can enhance the future cash flow of the company and potentially achieve a higher sale price for the enterprise by understanding and optimizing its key drivers of value. 

While these drivers vary according to the business — the industry, potential buyers, and the reason for the acquisition, there are a number of common categories of drivers that can add value to many operations. Identifying and optimizing the appropriate drivers for an enterprise can help the management team focus on strengthening the attributes of the enterprise that will be highly valued by prospective purchasers. 

Owners often consult chartered business valuators (CBVs) for assistance in understanding these value drivers because when they determine the value of a business for a business valuation, they look at the same factors that potential buyers do. As a starting point, consider that value and price for many operating businesses are a function of two primary components: the quantum of expected future earnings and/or cash flows and the quality of (or risk associated with) those earnings and/or cash flow.

Quantum of cash flow, referred to as maintainable earnings or cash flow, reflects the revenues generated by the business, minus the costs associated with generating those revenues. When valuing an operation, a CBV will study these factors, generally over a five-year historical period, because they can often be used as a starting point in estimating maintainable future results. A CBV will look for cash flow patterns — volatility or trends upward or down.

Generally, prospective buyers will place more value on cash flow that is expected to increase in the future, which indicates potential growth, rather than those that are stagnant or decreasing.

Companies considering a future sale should strive for strong cash flow generation with good expectations for future growth.  This can generally be accomplished through a combination of the following:

• Seek opportunities to grow and diversify revenue sources;
• Increase gross margins (e.g. decreasing direct costs);
• Control other costs (e.g. minimizing manufacturing, supply costs, overhead and other indirect expenses).

Understanding what drives the quantum of revenues and profit margins as well as growth opportunities will assist in identifying initiatives that management can undertake to increase cash flow and value.

The quantum of cash flow, however, should not be considered in isolation. The second major element in determining value is the quality of cash flow. Quality refers to the sustainability, variability and sensitivity to risks. 

The risk associated with cash flow is generally reflected in price by the multiple or capitalization rate applied. Many operating businesses are valued based on a multiple of earnings or the present value of future cash flow. The multiple or capitalization rate applied to the selected cash flow to convert it to the price or value of the business, reflects an expected rate of return for an investment and is, therefore, a key component of value.

The rate of return is a function of market conditions and rates of return in the marketplace, generally (e.g. interest rates), and risk factors specific to a business. While business owners cannot control market conditions, they can manage internal factors affecting the risk of their business.

Prospective buyers will often place more value on a predictable stream of cash flow than on one that is less predictable, or more volatile. Recurring cash flow — those that are likely to occur in the future based on past trends and current relationships, generally have a significantly higher value than one-time cash flow or a history of dramatically fluctuating cash flow. This assumes that history is a good predictor of future cash flow potential.

Companies considering a future sale should strive for improved quality of cash flow. This can generally be accomplished through a combination of the following:

• Increase the proportion of total revenues that are recurring in nature (e.g. repeat customers);
• Seek opportunities to diversify revenue sources and reduce customer concentration (e.g. new customers, product offerings, geographic markets, etc);
• Seek opportunities to improve consistency of gross margins;
• Reduce supplier dependence.

To determine the price or value of a business, it is important to recognize the interrelationship of the quantum of the cash flow and the quality. Management may initiate activities that increase revenues and cash flow, but those activities may inadvertently increase the risk profile — which may result in a decrease in value. 

Effectively managing the internal risk factors and responding to the external risk factors will impact a company’s quality of cash flow or risk profile. Some of the common drivers that can affect this profile, and the degree to which future cash flow can be realized by a prospective buyer, include the following:

1. Customer base

A company’s most important source of recurring revenue is its customer base. Prospective buyers often look for a growing base of loyal, long-term customers and the existence of long-term contracts.

In assessing the quality of customers, relevant factors may include historical sales trends, the size of the customer base, the number or percentage of new customers acquired each year, and the average number or percentage of customers that leave every year.

A high percentage of sales concentrated in a few customers and high customer turnover are serious acquisition risks because they may detract from future profitability. A management team can add substantial value by identifying ways to minimize attrition and to strengthen relationships, such as locking in contracts.

2. Management team

The depth and breadth of a company’s management team are important considerations when valuing a business. 

The strengths and weaknesses, such as experience and knowledge, of the existing management team are relevant in coming to a view as to its capability of managing the business going forward.

A team that shares a clear focus, a strong commitment to the company and follows a business plan that demonstrates the enterprise is prepared to deal with economic, competitive and other influences, would lower the company’s risk profile and increase the quality of cash flow. The length of time the team has worked together and the integrity and reputation in the industry of team members, can also add value.

To assess a team’s ability to deliver profits, relevant factors may include how well this group manages production costs, human resources’ requirements and quality controls — while delivering quality products/services on a timely basis. The team’s history of effectively handling challenges in view of the company’s past successes and failures should also be considered. If management has a track record of developing and executing successful business strategies and dealing effectively with uncertainty and change, this can add significant value.

A valuator would also look at the prospects for the future continuity of the team, including each member’s commitment to the company and what management contracts and incentive arrangements are in place to retain key managers. Compensation arrangements, share ownership, and personal investment in the business would be other factors considered.

Gaps in the management structure, over-reliance on the owner, or one or two key personnel, may be considered signs of a higher-risk profile. By addressing such weaknesses in the management team, a company can lower its risk profile and increase its value.

3. Workforce

The workforce can be a significant contribution, or an impediment, to the competitiveness of a company. Human capital is a major operating cost that requires effective and efficient management. For many businesses, employees and their skills are keys to deliver value to customers. Accordingly, potential purchasers and valuators would review a company’s investment in its workforce and the breadth and depth of its specialized skills and abilities.

To decrease the risks associated with the workforce (e.g. recruiting costs, labour shortages, etc.) management can look at ways to reduce turnover and stabilize the workforce through, for example, employee contracts, training programs and other incentives.

4. Market position

A company’s position in its marketplace also affects its risk profile. A strong position, such as an established niche, superior market share, excellent reputation, brand recognition, etc., decreases its risk profile and increases value. A weak market position has the opposite effect. 

Factors that may affect the future of the business may include: a company’s position in its market and relative to the competition, industry trends and economic conditions in general, such as growth/decline, pricing pressures, interest rates, etc.

Value detractors can include small size in relation to competitors, significant exposure to cyclical economic change, and concentration risks related to customers or geography. Value enhancers can include an international customer base, growing market share or distribution channels, documented plans for seeking growth opportunities or competitive advantages. In order to increase value, management should focus on improving value detractors and exploiting existing and potential value enhancers.

5. Strategic advantages

Strategic advantages of virtually any kind can add significant value to a business. Examples include strategic alliances, partnerships, brand recognition and intellectual property (IP). In fact, IP can be one of a company’s most important advantages. Patents, trademarks, copyrights, proprietary technology, trade secrets, and other forms of intellectual property are inducements for purchasers seeking competitive advantages.

Potential purchasers and valuators look for these key contributors to value — along with certain components that can add or detract from these. The value of trade secrets is particularly sensitive to the existence of appropriate internal procedures and controls. Other factors may include for example, the stage of development of the IP. Is it legally protected? Is it transferable? Does it have a track record of market acceptance and rates of return (i.e. is it proven)? What is its life expectancy in terms of the industry, legislation, economy, etc?

If a company has an IP advantage, addressing ways to protect and extend this advantage enhances the value of the operation to a potential purchaser.

6. Information systems

 Information systems are also an important determinant of value. Potential purchasers would consider a company’s ability to equip management with complete, accurate, timely and meaningful financial and operational information that facilitates effective decision making.

7. Financial leverage

There are two extremes when it comes to financial leverage — companies that are over-leveraged and those that are underleveraged and averse to taking on debt.

Instances of the first situation have increased in recent years because of the rapid growth of the private equity sector and the availability of inexpensive capital. Many companies have been funding transactions with very high levels of debt. While this may not be a problem when an enterprise is growing and can ably service the debt, companies in some industry sectors currently experiencing slowdowns are struggling with high-debt loads. Many prospective business purchasers are wary of debt thresholds that are challenging to sustain, thus magnifying risks and detracting from value.

At the other end of the spectrum are companies where shareholders personally assume all of the responsibility for financing the growth of the enterprise. Ignoring inexpensive external financing does not maximize corporate value if it restricts business growth. A healthy balance between these extremes is ideal for optimal value.  

8. Financial house cleaning

When valuing a business, a CBV would also assess whether “house cleaning” financial statements is required — whether the finances would be different if operated as though on behalf of an unrelated investor. Many family-run operations have a number of non-arm’s length transactions that need to be “normalized;” for example, they may provide compensation and perquisites to family members for services that do not always reflect the market value of those services. Similarly, inter-company rent should reflect market levels of rent.  

Cleaning up the balance sheet may also be needed to reflect the assets that are truly necessary in the business. This includes eliminating redundant (non-operating or idle) assets and redundant related-party debt balances and accruals. This would provide potential purchasers with a more transparent financial picture of the company. Otherwise, restatement of historical income statement and balance sheet information may be necessary. The fewer adjustments needed to perform this house cleaning, the better perception potential purchasers will have regarding the quality of financial information.

If the prospect of a sale is on the horizon, a company may need to spend some time to build a track record of strong performance. A benchmark valuation, and/or consulting with a CBV about the value drivers for the business, may be a wise investment to enable a business to identify and address the areas that will provide the best return for its efforts and resources.

Since the amount of analysis and explanation in a business valuation report is tailored to the intended use of the document, be sure to communicate the purpose of the report and the company’s expectations to the business valuator. The management team should also sit down with the CBV to discuss the report in order to draw out priority issues and identify key value drivers. A company can then establish goals and integrate them into its strategic planning process, with appropriate action plans and measurements.

For many mid-market businesses, the next few years will be crucial to positioning companies for a successful transition to new ownership. To enable a company to plan and execute initiatives that will improve its profitability, value and appeal — obtaining a business valuation may be well worth it.

Suzanne Loomer, MAcc, CA, CBV, is a partner in the financial advisory services division of BDO Dunwoody LLP (www.bdo.ca). She can be reached at sloomer@bdo.ca or 416- 369-3077.

* The BDO Dunwoody /COMPAS report on Canadian Family Business

http://www.bdo.ca/library/publications/familybusiness/succession/report.cfm. 

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