Business valuation: Key factors and how to assess a business's value

When you begin thinking about selling your company, among the first questions you’re likely to ask are, “How much is my business worth,” “Who evaluates the value of a business,” and finally, “Who can assess the business marketability?”

How to valuate a business

The answer can often be elusive and depends on a variety of factors that might not be evident to owner operators who lack experience in structuring and financing acquisitions. There are a lot of misconceptions about business valuation. This is due, in part to the myriad of ways in which businesses are valued.

Among the reasons for undergoing a business valuation are insurance buy-sell coverage, to obtain banking collateral and as part of the estate planning process. Transactional value is what willing buyers are likely to pay in an open market transaction. The price depends on the nuance of what a business or its assets are worth to specific investors at a moment in time.

Factors that affect the business valuation

The reality is that many factors influence the perceived value of private companies positioned for sale. These include:

• The current state of the mergers & acquisition (M&A) market and the cost of capital.
• Industry trends and how well the target company is positioned to benefit from them.
• The likely target market (i.e., types of buyers such as private equity firms, industry consolidators and large strategic buyers).
• “The story” supporting the company’s continued (or renewed) growth and profitability.
• The ability to address and reduce the risks that could hinder “the story.”

Buyers will review all of these areas and more to assess the value of the business and identify any additional investment that may be required to grow the company.

1. The state of the M&A market

As in other aspects of life and business, timing is a factor that is not completely in your control, but one that can make a significant difference. The current M&A market is strong, but there is a bias for clarity in areas that are often less important in boom times. This means that planning is more important: planning to have good answers, with data, to questions around customer retention and performance, supply chain risks and the quality of the management team. Companies who are prepared to address these issues generally have fewer pricing and structure challenges in the marketplace.

Some owners make the mistake of waiting too long to both assess these areas or to explore selling the business. They may be looking to execute certain growth and operating initiatives before starting discussions with buyers. However, if the company is performing well, waiting too long can be a mistake.

The industry in which a company operates, the broader economy or M&A and capital markets can change directions quickly. It’s best to explore options before you have to sell or retire. Going to market with good performance and a solid growth plan works regardless of general market sentiment.

2. The appeal of your industry and your business within it

A comparable consideration to the broader economic environment is the current appeal of the industry in which your business operates. Does your company serve a market that is growing or shrinking? Regardless, how is your company performing relative to its industry or peer group?

Investors may pay a premium for companies that outpace their comparable firms even in challenged industries. Outperforming them in a growth market is even better. The underlying concept is that organic growth for many is difficult and expensive. Buying a business to harness its success can result in a much more predictable return on investment for the acquirer.

3. How to find buyers

One key to a successful transaction is finding the most appropriate buyer for the opportunity. A starting point is to determine what you’d like to achieve as a result of the sale. While many may assume that the top priority is receiving the highest possible sale price for the business, that isn’t always the case.

Perhaps you want a buyer that will provide a high degree of support for the next tier of management to help continue to produce strong results. Maybe you want to maintain continuity of business leadership within a family or among current key employees. Your priorities can often help guide you to the right kind of buyer.

There are three primary types of buyers in the market.

• Strategic. These are larger companies in your industry who see revenue and efficiency opportunities that can be achieved through an acquisition and integration.
• Private equity. These financial buyers tend to be more focused on the quality and sustainability of earnings as a platform, along with sophisticated growth strategies. Private equity firms seek both new platform investments, as well as add-ons to existing platforms.
• Family office. Family offices have become meaningful buyers in private transactions. They’re looking for sustainable cash flows with reasonable growth. Family offices typically fund acquisitions utilizing more equity and less debt. They’ll consider both controlling and minority positions in private companies, invest for long duration hold periods and are not actively involved in operations.

It can be beneficial to match your own objectives to the pool of potential buyers in the market. It isn’t unusual to explore all three types of buyers to seek out competitive offers for the business.

Another factor to keep in mind is that those who are considering buying your business will likely have a better understanding of how the process works. Most acquirers have experience in the process, while sellers typically have not been in this position before or only rarely. A sell-side M&A advisor can provide effective management of the sale process with the right suite of buyers, creating significant negotiating leverage for the seller.

4. The importance of “the story”

Marketing a business for sale is more effective when there’s a story behind the business. In other words, it helps to undertake a process of “crafting a story” that can help define the business and its value to prospective buyers.

Working with professionals experienced in similar transactions can help sellers anticipate the critical questions likely to be the focus of potential buyers and then be in a position to prepare the best possible responses. Experienced sell-side advisors will help distill a narrative that explains the business and the attributes that create and sustain value.

In addition, telling “the story” of the company is a way to showcase the company’s strengths and potentially offer strategies to weaknesses that might not be addressable before a sale. These focus areas typically include:

• The quality and depth of the management team
• Factors that differentiate or shield the company from its competitors
• Facilities and equipment
• Scalability of operations
• Product lines and pricing strategies
• “Stickiness” or continuity of its customer base
• Clarity and visibility of operating margins
• Future growth initiatives

An underlying question from private equity investors is whether the target is a “big small company” or a one that is capable of transforming into a “small but growing company.” The difference is often in the architecture that underlies the issues that have been raised here.

5. Reduce risk for the buyers

Proving that your business holds a value that you think is appropriate has a lot to do with minimizing factors that create a perception of risk to buyers. Among the issues that can potentially detract from the market value of a business are:

• A retirement plan that leaves a knowledge, skill or retention gap to the new owner. It’s very difficult to replace an owner who has not groomed somebody to take their place.
• Failure to develop a “strong bench” of talent that “owns” core functions like finance, accounting, operations and sales. This gap creates expensive holes that buyers may need to fill.
• Insufficient investment in facilities, equipment and product development.
• Compliance or legal issues that could create exposure for the new owner after closing.
• Incomplete or inconsistent books and records that make it difficult to validate past performance.

The easiest way to think about these issues is to view the transaction as an investor or bring in an advisor who can provide that perspective. For example, working with outside accountants to provide financial schedules with thoughtful normalization adjustments can be extremely beneficial in the due diligence process.

In addition, showing sales and growth projections that are in line with the business’s recent history is valuable. This can add credibility as you seek to reach agreement on a purchase price with a potential buyer. 

Planning and professional help makes a difference

Most business owners are well versed in managing the day-to-day needs of their company. Few have experience in handling the sale of a business. In a market that can be as dynamic as middle market M&A, it’s important to have a guide with an updated road map to current themes, structures and valuations.

Owners should always be prepared to sell – even if it’s not their current goal. Planning can instill an importance to the factors discussed above. A business with less risk and a brighter upside is more attractive to outside buyers as well as a more attractive asset that can potentially be passed on to the next generation.

Considering transitioning your business? Find a financial advisor that works with business owners in your area.