Entrepreneur’s Wealth Digest
For many business owners, the process of getting a business valuation feels like a black box. You give your valuation expert your financials and out pops a number, right? How do you know what goes into that number and whether it is accurate?
This article is intended to shed light on that black box so that you can understand the key value drivers for your valuation. When we work with our clients, the focus is not only on the valuation number or, better yet, anticipated valuation range. We focus on what is driving that value and how can the owner improve their value.
There are three key areas of business value that we typically highlight for our entrepreneurs: transition risk, demand index and quality of financials. Notice that these omit things like revenue, EBITDA, growth rate or owner benefit. Those are certainly factors that have a significant impact. We do not tend to focus on them, because creating growth, profit and putting capital into the hands of owners are things entrepreneurs typically have a good handle on already.
In general, the more financially successful your business is, the more it is worth. I do not need to write an article to illustrate that point. What we at Entrepreneur Aligned focus on is how to maximize that financial success in the eyes of a buyer. Each of the three keys mentioned above serves to increase the probability that the cash flows a buyer wants will actually transfer over to them and continue. Let us dive into each and how they increase equity value and the price a buyer is willing to pay.
This is a category that encompasses a variety of factors that indicate how likely the present financial results of a business are going to continue after the transaction. It involves things like:
This is not an exhaustive list, and many other factors are considered based on the specifics of your business. It does, however, illustrate some of the most common elements we see that drive valuation. A business with 30% of its revenue coming from the top 10 accounts or clients is considered more stable than one with 90% of revenue coming from their top 10 accounts or clients.
Companies with patents, trademarks and non-disclosure agreements in place are more stable than those without those provisions, as a competitor cannot simply provide their product or service and take market share. Firms with solid ownership documents, management policies and procedures and non-compete or non-solicit agreements in place are worth more than those lacking those items. No buyer wants to buy a business without an operations manual or with key employees who could leave and take accounts with them. Finally, the more involved a current owner is in the operation of the business, and with their name involved in that business, the less that business is worth.
The saying in real estate is that it is all about “location, location, location”. The same can apply to business sales. Geography still plays an important role in current value and long term growth prospects for most companies. The same firm in San Diego will be worth more than if it were located in Des Moines. For companies who are entirely virtual, location is of course far less of a consideration.
Demand index also takes into account the demand for a particular firm based on whether its customer base is expanding or contracting. Think of a local travel agent versus an online travel concierge service. The local travel agent still has value, but the long term prospects for growth and demand for that business type will likely push the value down. So, the demand for your particular business and where it does business will be a factor in the valuation.
Quality of records
Many businesses may end up having to obtain a Quality of Earnings (QoE) report or something similar as part of the sale process. A QoE is performed by a Certified Public Accountant (CPA) or Certified Valuation Analyst (CVA) and is a deeper dive into your financials and legal documents that goes beyond your Profit and Loss and Balance Sheet. Typically, the last three to five years of your monthly financial statements will be reviewed. Customer lists and associated contracts will be verified. Detailed information on accounts payable and employee payroll and benefits will be double checked. This may also be accompanied by a legal review of all outstanding agreements and any prior legal exposure or litigation incidents.
If there are errors or inaccuracies found, your business’s value will decrease. Focusing on maintaining quality data and updated legal agreements along the way helps ensure that your books and records support the value you have established.
Valuation is not a black box or something to be feared. It provides us with great information to better understand how a buyer will view your business and allows us to increase your value year by year along the way. It can help drive both your business strategy and personal financial planning with clarity. Hopefully, this brief overview helped shine a light on an important piece of the entrepreneurial journey.
If you have a question or simply want to talk through your financial planning, we are here to help.
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DISCLOSURE: Jarrod Musick is an officer of Destiny Capital and Entrepreneur Aligned, a DBA of Destiny Capital. This article is for informational purposes only and should not be relied upon as a basis for your investment, business, or personal financial decisions. We recommend consulting with your wealth advisor, CPA/tax advisor and/or attorney, as applicable to your situation, prior to implementing any new tax, legal, or investment strategy.
Jarrod was born into financial planning and solving financial problems. With his financial advisor father Steve telling stories about finance around the dinner table from an early age, the idea that everyone has a different financial situation was always there. After an early professional career spent in nonprofit and government, Jarrod came back to his roots helping people plan and invest in 2011. Since then, he has worked with individual clients, led internal teams and ultimately became partner and the CEO of Destiny Capital in 2017. With a passion for helping entrepreneurs change the world, Jarrod ultimately oversaw the creation of Entrepreneur Aligned in 2020. With both Destiny Capital and Entrepreneur Aligned, Jarrod leads teams that help people live lives of abundance where money is simply a tool to let everyone be a positive force for the world around them. When he isn’t working with the talented teams for EA and DC you can find him chasing his twins, wily trout or a podium spot at an OCR race.