You’re considering whether buying and owning a business is right for you. You may know what your objectives are, what you’re willing to pay and what your income requirements are. But do you know that businesses in the same industry, of the same age, same size and same profitability can have major variations in valuation among them?
This is not to say that one company is overvalued and another isn’t. It is to say that seemingly similar companies may be very different in ways that both affect their value and how they fit with your objectives.
According to The Value Builder System™, there are eight drivers of business value. Strong drivers will make a company more valuable than other companies in its industry peer group. These drivers are:
1. Financial Performance
2. The ability to generate cash
3. Low dependency of the business on its owner
4. Growth Potential
5. Recurring revenue
6. Low dependency of business on key customers, suppliers, and employees
7. Customer satisfaction
8. Monopoly control
While all the drivers are important, we’ll look at the first two in more detail. We’ll also discuss the amount of day-today involvement you eventually wish to have in your new company.
Financial performance and the ability to generate cash
As a potential buyer of a business, one of the first things you are likely to look at are the company’s financial
statements. These will be a good indicator of the following:
1. The company’s ability to generate profits
2. The company’s ability to generate cash
3. The company’s ability to withstand risk
On the balance sheet, you should review debt levels and determine whether debt is increasing or decreasing over time. More importantly, figure out whether it is increasing or decreasing as a proportion as total liabilities and quity and where the break-even point is.
It is also important to see how much cash is generally on hand and how is it being distributed. For example, is working capital going up? Has the shareholder(s) had to extend loans to maintain adequate cash flow?
When reviewing the income statement, you should determine whether sales and margins are up or down When evaluating the sales and margins, be sure to take into consideration appropriate contexts, such as where the company is in its lifecycle, the overall state of the industry and any other relevant factors, such as market conditions.
The income statement will often have to be adjusted for personal items. Examples include excessive owner’s remuneration (or none at all), personal vehicle and health insurance and excessive maintenance expenses. Sometimes the owner will use the company’s products and services for his own use. In this case, the actual sales and gross margins will have to be adjusted.
Rising sales and margins are generally a good thing but are not always clear indicators of financial health. The table below lays out some potential implications of various sales and margins scenarios.
|Rising sales and rising margins||Margins and sales are sustainable||While both sales and margins are increasing, they are not increasing as fast as the general market, and the company still lags its peers.|
|Falling sales and rising margins||The company may be getting rid of unprofitable customers and product lines and will now be primed for more profitable growth.||The company is not investing in new product development or training. The rising margins are temporary, but the sales decline may be permanent.|
|Rising sales and falling margins||The industry might be very new and margins may fall to a lower, but still very adequate level.||The company may be chasing increasingly unprofitable sales.|
|Falling sales and falling margins||A company might be changing from a project based to a subscriber based revenue model. Initial revenue will go down and so will margins, but it could improve on both accounts.||Usually this is a negative indicator of company health.|
When you’re looking to buy a company, you’ll of course consider the various attributes of the organization, both financial and otherwise. However, it’s important that you understand your own personal needs and objectives and how a particular company will meet these. A key consideration is how much you eventually wish to be involved on a day-to-day basis. Most companies, except for quite large transactions, require a great deal of owner involvement.
It is possible that you expect to transition your involvement over time. For example, if you’ve worked in a particular service-area or profession for many years, you may be interested in purchasing a company in keeping with this experience. You should expect to have a significant level of involvement initially (working IN the company) but with growth and company development, your role could be less embedded (working ON the company). Likewise, you
may have the skills required to buy a “fixer-up” and turn it around, you’ll likely start with a high level of day-to-day involvement and as the company turns around, move from a working IN situation to a working ON situation.
From a purchasing standpoint, each of the scenarios involves different company attributes and costs to you as the
buyer, as well as different financial profiles as summarized in the following table.
Owner’s daily Involvement
(Trade or profession oriented small business)
|Low||Significant||Steady income.||Steady and sufficient profitability to pay owner.|
|Small to medium
(Minimal or no management team other than owner)
|Low to moderate||Significant, but could go down as company grows||Steady income, but also capital appreciation if company continues profitable growth||Profitable and growing with room for more growth.|
(Management team in addition to owner)
|Medium||Significant at first, but could go down as the owner and management team get used to each other||Continued significant growth with solid capital appreciation||Solid financial fundamentals with a company structure that allows for growth|
|Small to medium
(Turn-around or “fixerupper”
|Low||Significant at first with a view to reduce||Capital appreciation||Poor profitability and sales growth with perhaps significant debt. But there is something good about the company such as brand, products etc.|