I’ve been thinking lately that it all comes down to one question: What’s it worth?
Were the nights away from my kids, years invested in school, midnight sessions hammering away on my next book as I built my consulting business worth it? Was the time you invested selling, stressing, persisting as you built your business worth it?
I’m asking now, in my 40s, no longer from a philosophical point of view but from a practical, numerical perspective. What is that business that you built worth? And what would it be like if you could focus on just the right things, over the next few years, to double your business’ worth before you exit or pass your company on to your children?
Ironically, I’ve spent two decades helping clients increase the value of their businesses but never sat down, objectively, to apply that same advice to myself. I’ve studied all the key valuation approaches (growth, value, strategic value, cash flow, replacement, etc.) and I think it is actually pretty simple. You can double your company’s value in a relatively short period of time, say three to five years, if you focus on four drivers. Think of these as the four dials that, when properly set, can amplify what your business is worth:
- Cost of capital
The first aspect of your business to look at is revenue. Most business owners I’ve worked with focus on the absolute value of their business. They know that a $100 million business is worth more than a $10 million one. While this is true, if you want to increase your company’s value, you have to understand that while investors or strategic buyers say they care about what your revenue is, they are actually, unintentionally, lying.
Investors don’t care about what your revenue is; they care about what your revenue will be.
This seems a subtle distinction, but it is profound. Your revenue from last year is what it is. You’ve reported it to the IRS, it’s in your income statement, and honestly that is revenue that your would-be buyer will never get. Investors only care about your revenue to the extent that it is an indicator of what your revenue will be in the future, when they own it or own a part of it.
So what matters is not what your revenue is but what investors THINK your revenue will be in the future.
Humans, by design, look not at static images but at motion. It is hardwired into us, through millennia of genetic programming, to look for movement. The caveman who enjoyed beautiful foliage but failed to notice the predator moving behind the leaves died. While the caveman who noticed movement survived. A few thousand years of Darwinian selection produced humans, as most investors are, who look for movement.
When investors value your company, they will base their valuation on your revenue movement, your trajectory. This is baked into the discounted cash flow formula they use to value you. If they are pure investors, they will project out your growth – which will primarily be based on the growth rate your company produced over the past three years – to calculate what they are willing to pay. This means that if you can convince them to plug in 30% instead of 15%, you will double the value their formula pops out!
Now, I’m not advising this if your goal is to build a company that is built to last. If you have truly long-term goals – for example, if you want to leave your company to your grandchildren – then choose a more balanced approach. But if your goal is to double your business’ value over the next one to three years, then don’t worry about your absolute revenue number. Instead focus on your growth rate and focus on business that investors believe will continue (recurring revenue is better that deals you have to continually resell). This forces your would-be investor to input a higher expected growth rate, which multiplies your valuation.
- What must you focus on this year to maximize your growth rate over the next two years?
- What near-term opportunities (selling more to existing clients, pursuing customers ready to buy soon) will generate the greatest revenue growth in the near term?
- Which market segments offer the best immediate growth opportunities?
- Will investors believe your current revenue will automatically recur (e.g., because they are based on subscriptions) and if not, how do you address that today?
Your investors will also look at margin. Depending on your industry and the investors’ type, they may focus on different margins. In businesses in which strategic buyers could replace all of your back office activities with their own, investors will look at your gross margin. Private equity firms, which rarely centralize back office functions, focus on EBITDA (earning before interest, taxes, and depreciation). Figure out what type of margin investors in your industry care about and then optimize your strategy to achieve that.
If you go to www.valuations.com, enter in your basic data, and play with the profit margin, you can see how significantly increasing profit margin can enhance the value of your business. During our recent Outthinker planning session, we used the valuations tool and it hit us that, because our average profit margin is about double that of the average for our industry (business consulting), our valuation would be more than double that of a more traditional competitor.
So, seek strategies to show that your particular business model produces an above-average profit margin. Consider these levers:
- Can you increase price (most companies can increase profits by 10 to 20% by just improving how they price)?
- Can you reduce process costs?
- Can you reduce sales, general, and administrative (SGA) costs?
- Can you improve profit per employee?
- Can you establish more efficient distribution partners/channels?
- How can you trim production costs or cost of goods sold (COGS)?
- Are you targeting the most profitable customer segment?
- Do you have the optimal product mix?
- How can you increase employee productivity?
If you can eke out even 1% higher profit margins through initiatives that derive from these questions, you could increase your business’ value by 10 times.
Cost of capital
Fundamentally, a business is only valuable if the return it gets on investing in itself (e.g., producing new products, building new factories, hiring new people) is greater than the cost it incurs accessing that investment. You must borrow at, say, 5% and invest at, say, 10%. Otherwise, you are better off keeping that money in a bank.
Investors are going to want see that you have a “golden goose,” that your company is able to turn 5% into 10%, that you are a perpetual value-creation machine. Your efforts to increase revenue growth and profit margin help ensure you achieve high returns. But they are only valuable if you are able to simultaneously keep down or reduce your cost of capital.
So explore ways to reduce your average cost of capital:
- Can you borrow more money to buy off equity investors? (Taking on lenders is generally less expensive than taking on equity holders, but you must make sure you are not taking on more debt than your profits suggest is safe.)
- Just as you might refinance your home when mortgage rates decline, have you looked for lenders and investors recently who would offer you better terms?
- Can you reduce the cost of your equity holders by, for example, issuing preferred stock in exchange for non-preferred?
Every industry carries a different multiple. Investors will look at your revenue or profit and multiply that by some industry-average multiple. The logic is that if this is what other investors are willing to pay, then if I buy at the same or lower multiple, I will eventually make money.
To be honest, I find the logic short-sighted, but this is how most investors think, so why not use it to your advantage?
If you can reclassify your company in the minds of investors into a new industry or sector, you could magically increase the multiple they apply to your business. For example, if you are primarily a TV broadcaster, at the time of this blog’s writing, investors would pay about four times your earnings for your business. But if you were primarily a radio broadcaster, then they would pay 51 times your earnings! So, if you can, through some divestitures and acquisitions, get investors to see you as being in the radio business rather than TV, you could dramatically multiply your value.
MasterCard has applied this principle well over the past few years. By transforming itself from a financial services company (which investors would value at 15 to 20 times earnings) into a technology company (which investors value at as much as 30 times earnings), they have multiplied their value.
- In what sector or industry do investors currently categorize you?
- Into what new sectors could you reasonably transform yourself?
- What are the multiples investors apply to these new industries? (Go here or here for ideas.)
- What strategic initiatives should you undertake now to begin redefining your industry?
I’ve created a workbook to help you generate specific strategies to help you use these four levels to multiply the value of your business. Fill in your information below to get your free copy.
photo credit: bogenfreund via photopin cc
Sign up to get free workbook