Most small businesses do very little formalized planning. Even bigger companies with good planning processes rarely focus on growing the market value of their business. Most investors look for some combination of current income and long-term capital gain. Owners of private companies should be no different. Growing the market value of the company should be an expectation for the management team. Where management focuses its time and energy can make a huge impact on the market value of a business.
5 Key Areas of Focus
Build the Team
Most smaller companies are the product of a strong, entrepreneurial founder or family. Some have successfully replaced the founder(s) with qualified professional management. Either way, market value is greatly impacted by the depth and quality of the management team. This is especially true through the lens of financial buyers such as private equity funds and family offices. Strategic buyers can be concerned about management depth, but not always. Reliance on a single key leader will usually be a red flag to potential buyers. It is always viewed as a risk and negatively impacts value. Financial buyers often name quality and depth of management as their primary investment criteria.
If the goal is to build value, succession planning and team-building is essential. Most potential buyers must be convinced that the seller can be readily replaced in the near term. The best way to illustrate that is to replace yourself now or have a strategic succession plan in place.
Motivating and retaining top talent is crucial for the sale value of your company. Does your management team have the leadership acumen, skills and drive to continue growing the company when you leave? A strong and motivated management team demonstrates to buyers that the value of the business is not completely dependent on the company’s owner.
Institutionalize the Business
High performance teams develop and follow proven processes and procedures. I call it institutionalizing the business. It makes results less dependent on any individual and more reliant on the success of the team being trained who consistently follow standard operating procedures (“SOP”). For this to be effective the SOP need to be well engineered, repeatable and easily understood.
Employees come and go, but the systems that run the business remain constant. Having proven, standard processes means your customers, vendors, and employees enjoy the same experience each time they interact with your company. It also means your company enjoys the benefits of the efficiencies as a direct result.
Focus on positioning your business to rely on properly managed procedures and systems. Using state-of-the art software systems/processes effectively can give your company a competitive advantage, even against your larger competitors. Ask yourself the question: is my management team up to the task of finding, training, and implementing such systems in our company?
Diversify the Customer Base
Many lower middle-market companies have made the mistake of growing revenue by exacerbating customer concentrations or chasing marginally profitable customers and markets. The resulting customer/industry concentrations and reduced profit margins are detrimental to market value and reduce the marketability of the company.
In today’s M&A market, astute buyers focus a great deal of their due diligence on the target’s customer base. They are wary of both individual customer and industry concentrations. A single or a few large customers amplify risk as does a customer base that serves a single end market.
Buyers typically look for a customer base in which no single client accounts for more than 8-10% of total sales. A diversified customer base insulates the company from the dramatic impact the loss of a single major customer can have. It should also serve to protect the company from the pressure on pricing and margins that can be exerted by a single major customer.
Work to diversify the customer base by number, size, industry and geography.
Develop Streams of Recurring Revenue
The reason that recurring revenue is a value driver should be evident. Every business would like to start the month or even the year with a high percentage of their targeted revenue in the bag.
That said, for many businesses; it is difficult to create customer relationships that cannot be undermined by competitors. Look for strategies that enhance recurring revenue and address competitive intrusion.
- Make customer retention a top initiative
- Offer a compelling customer value proposition
- Consistently beat delivery dates
- Illustrate continuous innovation
- Consistently deliver better quality
- Be the most convenient solution
- Provide the best customer service
- Generate creative offers and pricing
The larger the portion of a company’s revenue that is recurring, stable and likely to continue in the future, the more desirable that company is to prospective buyers. In addition, multiple revenue streams – the number of different ways the business earns money – can help reduce the risk should any single product or service see a downturn. Buyers are more willing to pay a premium for businesses that demonstrate predictable earnings.
Demonstrate Rapid Growth Potential
Market value is maximized when there is a consistent track record of growth that projects into the future. Prospective financial buyers want to understand the growth story before asking any further questions. A compelling growth opportunity goes a long way toward the development of their investment thesis. It cannot be “pie in the sky”. The recent track record and underlying explanation is foundational. The story is always enhanced if accompanied by an extremely large addressable market for the product or service, meaning a market with lots of opportunity and room for growth.
Rapid growth-potential hinges on scalability. Many things need to be in place for a business to be truly scalable. If rapid growth would require a significant capital expenditure investment, then the story becomes less compelling. A truly scalable business is one which does not require near term capital expenditures to support the growth plan, and will see profit margins increase as revenues increase. Profit margins increase because costs do not rise in lockstep with revenue.
The software business model is a classic example of a scalable business. The cost to deliver the software, once created, can be almost nothing. The additional licensing revenue received increases revenue, profit margin, and cash flow.
There are obviously many issues that can negatively impact market value. Examples would be lack of pricing power, unusual exposure to rapid technology changes and lack of capacity to support growth. The key to growing market value is to focus on the actionable key issues and measuring results. Many of these issues can be dealt with effectively if given enough time and attention. However, if they are not addressed, they will have a negative impact on market value and marketability.
About the Author David Engel
David is a trainer for IdeaTeam1 and a Consulting Partner at Flynn & Company. David brings more than 30 years of corporate transaction and financial advisory experience to clients’ business challenges.
He has an extensive background in developing, defining, and executing M&A strategies, ownership transition of privately-owned businesses, corporate divestitures (including carve-outs), management buy-outs, recapitalizations, business valuations and capital formation.