Excluding liquidation or break up value, there are only two fundamentally different models for establishing a value for an operating business. The first is based on the future stream of free cash flow generated by the business and the other is the strategic value of the business to a large corporation.
Most conventional businesses, such as retail, wholesale, transport, property, and services businesses, achieve value by producing profits (EBIT) for the new owner.
It is the size, duration, growth and likelihood of that profit stream that creates the value. By the way, it is only ever future income streams that create value never past ones. You don’t put money into a savings account to get the interest rate the bank paid last year, the only relevant rate is the one they are going to pay.
While past profits may give you some indication of the likelihood of future profits, you can dramatically improve your valuation by creating a different future.
You reduce risk by improving recurring revenue, account penetration, customer and employee churn and by implementing better systems and processes internally to set and monitor performance.
Visibility of future income streams is improved with long-term contracts, greater recurring revenue and deeper account penetration as well as establishing good competitive advantage around patents, brands, trademarks and deep expertise. This should gradually improve the EBIT multiple. Further increases in valuation will come from increasing sustainable profitability and building income (EBIT) growth in the business.
This process is fairly conventional. Now comes the clever part! To gain a premium on the sale you can build growth potential into the business which the buyer can exploit.
Can you identify how a much better funded, more skilled, more able buyer could grow your business, and can you provide the framework or template for that growth? Where you can set out a path for higher growth and profits and clearly demonstrate how that can be achieved, it is possible to gain some of that increased profit in your valuation. But you will need to find the right buyers and you will need to put the business into a competitive bid in order to extract that premium.
A business that has underlying assets and/or capabilities which a large corporation can exploit is a very different proposition. These are business based on patents, brands, copyright, trademarks and deep expertise.
The valuation in this case is not based on what your business can generate in future profits but how much profit the buyer can generate by exploiting your underlying assets and capabilities.
Imagine a very large corporation that has a customer base one hundred times yours, which would be highly receptive to your product or service. The large corporation may be able to quickly sell your product or service into an existing customer base reaping 10 times your revenue, or greater, in the first year of the acquisition.
Therefore, what would your business be worth to a large corporation that had a ready market for your product or service? The value of your business is based on what they can do with your business not what you can do with it. In fact, your own revenue, profits, customers and numbers of staff may be quite irrelevant in putting a value on your business. It is now all about them and not you.
Working out a valuation based on strategic value is very difficult but not impossible. What you have to do is estimate the revenue and profits that the acquirer will generate from your business.
Thus, if they have a customer base one hundred times yours, then it might be fair to say that the value is one hundred times your conventional valuation. Will you get that for your business? Probably not but you will gain some portion of that value if your set the deal up correctly with the right potential buyers and ensure you have a competitive bid running when you come to sell.
With strategic selling the task is to work out what you have or do which could be of interest to a large corporation, identify the potential buyers, set up a relationship to educate them on your potential and then manage the final competitive bid. Generally strategic buyers are prepared to pay many times the conventional value of a business.
If you compare these two models, what you will see is that the value of your business is solely in the eyes of the buyer and especially in the manner in which the buyer can exploit its potential.
What this should be telling you is that the identification of potential buyers is one of the most critical aspects of gaining the best price for your business. The best buyers are the ones which have the experience, willingness, capacity and capability to best exploit the potential in your business. Your task then is to create that potential and then find the right buyers.
Source: Smart Company Newsletter 12 April 2007