In 1912, the world’s largest movable object set sail. The British passenger liner, the Titanic, was the most sophisticated and luxurious ship of its time and was billed as unsinkable. Cruising at 22 knots near Newfoundland, the Titanic struck an iceberg, sinking the vessel, resulting in the loss of over 1,500 lives. The culmination of ego, competition, high speed in icy waters, and an attitude of infallibility created one of the largest maritime disasters in history.
The iceberg is indeed deceptive with only 1/10 of its volume residing above the water line leaving the overwhelming mass lurking beneath. We often hear owners lament how unique, grand, and indestructible their businesses are. They point to easily visible metrics such as revenues, brand name accounts, and marketing collateral to paint a picture of stability, growth, and opportunity. After all, it’s the owner’s job to share their story and paint a picture of “success.”
Surface Metrics in Business Valuation
Based on the following data points, which company likely offers more value?
Comparing Two Companies on Surface Metrics
Company A
$10M in annual sales
$1.8M EBITDA
Flat 3-year revenue growth
Company B
$20M in annual sales
$4M EBITDA
5% incremental growth over the last 3 years
Based upon the data provided, the majority of us would choose Company B due to larger revenue, slightly better EBITDA, and sequential growth trend. This is the proverbial “tip of the iceberg,” highlighting Company B’s readily discernible performance. These three metrics are only the beginning of a much deeper exercise in determining ultimate value. So what lurks below these surface metrics that may enhance or detract from the actual market value?
Looking Below the Surface for True Business Value
Let’s probe a bit deeper below the surface:
Key Factors Affecting Valuation
How many hours per week does the owner work on average? How dependent on the owner(s) is the business in relation to sales, operations, R&D, etc.?
What is the depth and overall quality of the management team? Is there a critical reliance on any key personnel?
What is the diversification of the customer base? Does any one account generate in excess of 15% of total revenues?
What is the diversification and stability of key partners (suppliers, key vendors, etc.)?
What is the diversification of product offerings? How is the organization vertically integrated or offering value-added services or products to grow share?
What are the “switching costs” for a customer that contemplates leaving for a competitor (contracts, usability, business interruption, service delivery, etc.)?
How stable are the gross margins, earnings, and cash flow over the last 3 years? How heavily leveraged is the company?
What is the current state of the industry and specific geographic market served?
How developed and scalable are the various systems within the organization, and how readily could a new employee get up to speed?
What types of intellectual property exist within the company, and how is it protected?
Beneath the Surface: Company A vs. Company B
Let’s now revisit our two sample companies and delve beneath the “water line”:
Company A
Owner works 15 hours a week in the business.
Owner does not have significant responsibility for sales or operations.
Management team has been together for 6+ years, with non-competes, clear measurements, and an active phantom stock program.
Less than 4% of total revenues are with any single account.
Contracts exist for over 40% of the customers and are assignable to a third party.
The company has 3 pending patents and federally registered key portions of their intellectual property.
Company B
Owner works 60 hours a week in the business.
Owner generates 40% of the annualized sales.
New CFO, COO on board for 8 months, and they are seeking a new Marketing Manager.
32% of total revenues are with one large retailer.
Contracts exist for only 5% of customers and are not assignable.
The company has not protected their name, key URLs, trade secrets, or proprietary processes.
How Do These Factors Impact Valuation?
How do these answers change your perspective on the ultimate valuation? Valuation is ultimately based on the perceived risk to the buyer. Which now represents the greater risk, and how might that risk play into the valuation as well as the terms of sale?
Company B likely sells for 4X EBITDA = $16M. Sounds great until you realize that the buyer will only give you 20% cash up front and the rest will be based on a complicated series of performance caveats, your ongoing involvement, and a large note payable stretched over 5+ years. Your life’s work was reduced to $3.2M (before the IRS takes their cut), and you’ve now got a new boss who doesn’t think like you.
Company A likely sells for 7X EBITDA = $12.6M. The buyer offers 60% up front = $7.56M with a 3-year note, achievable performance caveats, and a 6-month consulting agreement with you to help facilitate the transition.
This basic illustration demonstrates that growth doesn’t always equate to value. Often, fast and uncontrolled growth can be as fast a killer as slow to no growth. Building value requires a deliberate and focused approach with a competent team of experienced professionals.
Building Lasting Business Value
If you’re like the majority of owners, you’re gifted in your chosen profession and have achieved a level of success most never realize. With an average 75% of your asset base locked inside your business and the majority of your week chained to the desk, having an independent and objective resource to help you identify, prioritize, and implement growth solutions can have a very large impact on your current quality of life, future valuation, and in the preservation of the legacy you created.
Contact us for a free 90-minute consultation at info@flvcp.com.
