In recent articles we’ve described several value drivers or characteristics that give businesses the enduring strength, profitability and increasing cash flow that make them more fun for owners to run today and more attractive to buyers some day in the future.
We’ve already discussed:
Today we complete the list with a brief explanation of the other six and offer suggestions about how you can help your clients to evaluate the strength of each.
- Diversified Customer Base
- Recurring Revenue That Is Sustainable and Resistance to “Commoditization”
- Good and Improving Cash Flow
- Demonstrated Scalability
- Competitive Advantage
- Financial Foresight and Controls
We know that many of our members turn to the business consultants on their advisory teams for informal advice or formal analysis of their clients’ company’s value drivers. Unless it falls within our core expertise, none of us feel comfortable advising an owner on how to improve a particular value driver. The Exit Planning Process, as we practice it, relies on the suggestions and recommendations of a team of advisors that includes, with respect to value drivers, a variety of business consultants.
Your role as an Exit Planning advisor is to explain the importance of value drivers in creating transferable value and suggest resources (e.g. an experienced business consultant).
Diverse Customer Base
Buyers typically look for a customer base in which no single client accounts for more than eight to ten percent of total sales. A diversified customer base insulates a company from the loss of a major customer. For example, if the top three customers generate 25 to 40 percent of sales, buyers are justifiably concerned with the prospect of one or more of them jumping ship once the present owner leaves. To a lesser extent, insider buyers share this concern if the biggest customers are loyal to the owner, rather than to the company or other employees. Customer concentration then, is a risk factor to be avoided regardless of exit path.
Consider the owner who considered his $30 million (revenue) printing company to be an ideal acquisition candidate and decided it was time to sell. While the company had both growing revenue and cash flow, there was one glaring problem: 85 percent of its revenue came from just five customers.
When the investment bankers took it to market there was no serious interest. Otherwise interested buyers were concerned that the loss of even one of the five customers (and certainly two or more) would seriously reduce revenue and earnings. When the business finally did sell, the buyer demanded a 35 percent hold-back and a purchase price reduction if more than one of the five largest customers left within 30 months of purchase. The purchase price multiple was at least 20 percent below the investment banker’s expectation—due to the risk buyers perceived.
Evaluating Diversification. Had this owner expanded the customer base so that five largest customers were, say, less than 40 to 50 percent of the revenue and profitability, the buyers would not have been as risk-averse. Encourage your clients to evaluate their companies’ customer bases through buyers’ eyes. Without knowing the relationship between company and customers, would they assume that risk?
Recurring Revenue and Resistance to “Commoditization”
In the prior article, The Role Of A Growth Strategy In Transferable Business Value, we met “Yolanda” the owner of “ABC Co.”. ABC had steadily improved revenue to $8 million, but profits were decreasing. This is a classic indicator that commoditization was occurring in her company’s business niche. Operating margins decreased even as revenue increased.
You may wish to view this as two value drivers:
- recurring, sustainable revenue and
- providing products or services resistant to commoditization.
The reason that recurring revenue is a value driver is evident: Buyers are attracted to companies that print money with the push of a button. If a company’s services or products are resistant to commoditization, they can reasonably expect the company to continue to print money.
Yolanda countered the downward drift of her company’s profit margins by taking two important steps: First, with the help of her Exit Planning advisor she recognized that neither she nor her management team had the skill sets and experience necessary to change course. Second, upon her advisor’s recommendation, she hired a consulting firm and, through them, installed a management team with the higher-level skills and experience needed to create a growth plan that addressed declining operating revenues and accelerating revenue growth.
Evaluating Resistance. It’s difficult to create any useful product or service that can’t be quickly imitated and commoditized by competitors, but there are numerous strategies that enhance recurring revenue and address commoditization.
Scott Barth, a BEI member and business consultant from Wheat Ridge, Colorado suggests continuous innovation, segmenting, disciplined ranking of A, B, C, D customer types, value-added services, bundling, unbundling, helping customers quantify the value of your company’s solutions, and compensating sales on profit margins vs. sales revenue.
Not all of these strategies are appropriate for every company. Others, not mentioned by Scott, may be more suitable. Selecting the best strategies and incorporating them into the Exit Plan you create for clients is critical. As you create your network of advisors, make sure to include professionals who can recommend the best strategies for your clients.
Good And Improving Cash Flow
Ultimately, all value drivers contribute to good and increasing cash flow, and buyers look for companies whose cash flow is increasing year over year. For example, compare two businesses, each experiencing $6 million of cash flow over the last three years. One company’s cash flow was $1 million three years ago, $2 million two years ago and $3 million last year. The second company had $2 million of cash flow in each of the same three years. Which company is worth more to buyers? The company with growing cash flow. Its track record of steadily increasing revenue can be convincingly projected into future, post-sale growth.
Evaluating Cash Flow. When you review the past three years’ annual cash flows of your clients, are they trending upward? If not, in the growth plans that you create, include specific recommendations regarding which value drivers must be strengthened to provide the necessary increases in future cash glow.
A scalable business is one in which profit margins increase as revenues increase. As you know, profit margins increase because costs do not rise in lockstep with increasing revenue. For example, most professional service firms are not highly scalable because revenues are based on an individual’s billing rates. To increase revenues, increase the number of professionals; in other words, costs rise in tandem with revenue.
Compare that to a business that licenses software to that professional service firm—the cost to produce the software, once created, is almost zero. The additional licensing revenue the company receives increases revenue, profit margin and cash flow.
Evaluating Scalability. Other value drivers (such as efficient operating systems and processes) as well as a company’s business model can improve profit margins as revenue increases. Think about a computer app like Angry Birds. There is a fixed cost to design and test, but additional sales do not increase those costs. Yes, scalability is a bit more difficult for, say, a hardware store, but not impossible: if the hardware store enjoys high profitability and strong revenue growth, it likely has many of these value drivers in place, including a competitive advantage. If these value drivers can be replicated, a business can achieve scalability by establishing new stores in different locations using the same value driver model. Think: Apple Store.
To paraphrase Michael Porter of Harvard University’s Business School, competitive advantage is the product or service that a company offers—either better or more cheaply—over time than does its competitors. A company’s competitive advantage is the reason customers buy from it instead of from its competitors.
Evaluating Competitive Advantage. Your clients may well know their company’s competitive advantage or they may not. Or, they may not have one. If a company lacks a competitive advantage it competes on price alone. It is worth spending time probing this value driver with your clients and their management teams. When you uncover a competitive advantage you’ll want to do everything you can to help your client to protect and promote it.
Financial Foresight And Controls
As does recurring revenue, this value driver also has two aspects. The first relates to financial controls or reporting. Many companies lack reliable financial reporting to such an extent that buyers can’t determine what the company has or track the source of its revenues. Usually, this problem is correctable, but it takes time to do so. More importantly, sloppy financial reporting can indicate to buyers that there’s an underlying problem, the most benign of which is that owners and management lack a clear understanding of their company’s financial performance.
The second aspect is less apparent, but more important. If a company is to grow substantially and quickly, it “has to be fed.” As you create growth plans for your clients’ businesses, you must project the cash flow cost of implementing the plan. Project at least one year ahead in order to give owners time to arrange financing if necessary.
Evaluating Financial Issues. Having a firm grip on the financial condition of the company is a critical owner responsibility because, after all, it’s their signature on all company loans and other obligations. With your advisor team and your client’s CPA or CFO, forecast the financial demands of the growth plans you create. If a plan calls for substantial and rapid growth to meet an owner’s goals, it may take more than the cash flow of the company to support it. Secure bank or other financing before your clients are in the middle of expansion, only to find themselves running short of cash.
Don’t be surprised to find that many owners believe that these value drivers apply only to businesses considerably larger than theirs. Your job as an Exit Planner is to show them that this is not the case. Owners must work to make their value drivers strong or companies both large and small will stagnate.
What is unique to smaller companies is that growing transferable value to the level owners need to attain their goals likely requires skills and experience beyond their pay grade. Most owners need to look to others—next-level management and outside consultants like you—who have that experience and skill.