Article written by:
Craig Hickey, CPA
Director, Valuation Services
According to some estimates, there is an estimated $10 trillion of wealth that will be transferred to younger generations over the next decade, and it is never too early to begin planning and preparing for that inevitable ownership transition. With the goal of maximizing enterprise value, there are several factors that should be considered prior to selling. Knowing what drives value and what a typical buyer wants to see in a business will help a business owner manage a business with valuation in mind.
Valuation is ultimately derived based on the expected future cash flows of a company. Since the future in uncertain, this uncertainty creates risk; therefore, a buyer will also determine a discount rate which accounts for the risk of achieving the projected cash flow. Therefore, in order to maximize enterprise value, the focus should be on increasing cash flows and minimizing the risk. Here are a few things to consider:
- Sustainable and Growing Cash Flow: The first consideration is to evaluate how sustainable current levels of cash flow are, then having a plan in place to grow cash flow. If the cash flow is not reliable, it may be a sign that the business is not performing optimally and may not be a good investment for a potential buyer (i.e., the cash flows are risky). An owner being able to demonstrate a clear and concise plan to sustain and grow cash flow helps to optimize valuations.Another item to consider here is the presentation of the financials and the overall financial controls of the company. A potential buyer will likely perform a quality of earnings analysis to examine the financial statements and assess whether or not the financial statements are a good representation of company performance. Having reviewed or audited financial statements helps to exhibit that the financial statements are accurate and fairly represented.
- Evaluate and Decrease Risk Factors: Investing in businesses is inherently risky, so it is important for small businesses to decrease the risk factors that they have control over, which in turn will increase valuations. Risks that we commonly see that can be mitigated with proper planning include:- Customer and Supplier Concentration: Diversification is important to mitigating risk. The more a company depends on a handful of customers to generate the bulk of revenue, the riskier those cash flows become because the loss of a single customer can dramatically alter the Company’s cash flow generating capabilities. Ideally, no one customer should contribute more than 10% of total revenue. Further, having more than one supplier to source materials and supplies is critical to decreasing operational risk over the long-term.- Key Employees: Not all employees are created equal and some employees are key contributors to the overall health of the business. Further, oftentimes sellers will want to step away from the business and move on to the next chapter of their life post-transaction. As such, it is important to have a succession plan in place for key employees to reduce risk related to these employees leaving the company. Further, having incentive plans or employment contracts in place also helps reduce this risk.
Preparing for a sale can be a multi-year process involving a lot of planning and preparation. GBQ is a full-service firm that can provide assistance throughout the entirety of the process – from assurance and tax planning/structuring to valuation and sell-side advisory.