Business owners, knowingly or not, are trying to increase the value of their business each and every day. A simple understanding of how business value is calculated can provide more focus on areas that can significantly increase the valuation of your business.
Why should entrepreneurs strive to build valuable businesses?
Having worked with hundreds of small to medium size business, I have noticed that the two most common reasons people start their own businesses are to get rich and find work-life balance. Focusing your efforts on building a valuable business can help achieve both of these goals.
For many, entrepreneurship has been a lucrative wealth creation vehicle. Research shows that 80% of pentamillionaires (those with a net worth of $5 million or more) are entrepreneurs who grew and sold their companies.
The connection between work-life balance and building a valuable business is less obvious to most entrepreneurs. Valuable businesses have well established processes that allows the owner to spend less time on day-to-day operations if they so desire. When selling the business, a would-be acquirer gains confidence that the business will continue to run smoothly in the owner's absence. Buyers are willing to pay premiums for companies that demonstrate this characteristic.
The Math Behind a Business Valuation
Technically, a company's value is simply the sum of the present value of all future cash flows. The present value calculation takes into account the amount of cash flow the business can generate into the future, discounted at a rate of return that could be earned on an investment in the financial markets with similar risk.
Based on this formula then, a business owner could focus on these three areas to increase value:
- Free Cash Flow: A company that has the ability to generate significant and consistent free cash flows will command a higher value. Focus on activities that will drive higher profit margins and build processes around lead generation that will ensure a steady revenue stream.
- Rate of Return or Risk: There is an inverse relationship between risk and value. An entrepreneur's intuition will tell them that if there are two companies with exactly the same cash flow, the one with the least risk is more valuable. If all efforts are driven to reduce the risk of the business, inversely the value of the business will increase as will the attractiveness to potential buyer. To assess areas of risk in your business, put the shoe on the other foot. If you were buying a business, what would you find to be a risk factor causing you to pay less? The key is then to develop written plans and processes on how to mitigate the risk areas.
- Timing: The presence of potential acquirers in the market, availability of capital and the general economic environment will all impact the value of a business. It is imperative that business owners remain constantly aware of what is happening in the market place on the acquisition front. Are banks lending capital for acquisitions? Are there serial acquirers in your industry that might pay a premium for your business? When it comes to valuation, timing is everything weather by luck or by design.
Simply put, an entrepreneur needs to increase cash flow, decrease risk and prepare to take advantage of appropriate market place dynamics to maximize the value of their business. Focusing on these three principles can provide the great rewards of financial abundance and freedom to focus on areas for the business you are passionate about. Isn't that why you started a business in the first place?
John Carvalho is President of Stone Oak Capital Inc.(www.stoneoakcapital.com), an M&A advisory firm, as well as co-founder of Divestopedia (www.divestopedia.com), a resource for entrepreneurs who want to sell their business at maximize value and on their terms. For over a decade, John has served his clients on numerous valuation, acquisition and divesture assignments in a wide variety of industries.