Because of this, buyers favor companies with predictable earnings, a varied customer base, experienced employees, and limited reliance on the owner’s personal relationships and knowledge. Companies with these characteristics will generally be valued higher than similar companies without them.
A business valuation considers these same factors when estimating value. Strong revenue and profitability help establish the potential range of value for a business, but the transferability of those earnings will substantially impact the final business value conclusion.
Consider two commercial print shops. Print Shop One mostly services long-term supply contracts for government agencies and large corporations. Print Shop Two mostly services small jobs for local advertisers, with more seasonality and variability over short-term economic cycles.
If all other factors are equal, Print Shop One will likely be valued higher than Print Shop Two. This is not because the business is inherently better. It is because a buyer of Print Shop One will have immediate, predictable cash flow when they assume the existing supply contracts. They can be reasonably confident that the business will generate sufficient working capital during the ownership transition.
Print Shop Two may have similar annual earnings, but its buyer does not know whether the first three to six months of operation will produce sufficient cash flow to keep the business running comfortably. The buyer risks a working capital shortage if they take over the operation during a down cycle.
Risk and value have an inverse relationship. The risk of acquiring Print Shop Two is higher, so its value is lower. The predictable earnings of Print Shop One reduce the buyer’s risk and therefore increase its value.
Many business owners are proud to have become the premier option for niche products and services. Specialization is commonly promoted as a reliable way to reduce price competition. However, while specialization may increase margins for the current operator, it can also limit the customer base.
Consider a machine shop fully dedicated to manufacturing parts for a limited number of aerospace programs. The shop has invested in the capacity and expertise required to be a premier supplier for these products and operates very efficiently.
This business may have excellent margins, but its customer base is highly concentrated. A change in the political landscape or reprioritization of government spending could result in an immediate loss of revenue, large retooling expenses, and downtime while new contracts are pursued.
A business buyer will see this revenue as riskier than the revenue of a shop with similar earnings but a wider variety of customers and income sources.
Once again, risk and value are inverse. All other factors being equal, a business with high customer concentration is riskier, and therefore less valuable, than a business with a more diversified customer base.
For small businesses in particular, sellers often confuse earnings with value. An owner who has made a great income and lived a great lifestyle may be very happy with their business. But that doesn’t mean anybody will pay them for it!
Businesses are not valued based only on what a seller has earned in the past. Buyers care about what they can earn in the future. A business which is highly dependent on its current owner faces a greater risk of decline when that owner leaves.
The buyer has to consider what happens after the departure of the current owner. Will key employees be willing to work for somebody else? Will longtime customers take the opportunity to shop for new vendors? Will processes falter without the knowledge stored in the owner’s head? Will suppliers honor longstanding informal pricing agreements?
If any of these unknowns develop unfavorably, the buyer could find themselves unable to continue the earnings enjoyed by the prior owner. This increased risk can reduce business value.
Business sellers can mitigate many of these risks with pre-sale planning. Recording processes and procedures can help the new owner make decisions without the seller’s daily input. Formalizing vendor agreements can reduce the risk of unexpected price changes. Working to retain key employees reduces the chance that the new owner will have to immediately replace important staff. Carefully transitioning key customer relationships gives the new owner time to develop trust among the customer base.
Businesses with systems, management, and relationships that exist outside of the current owner will generally be more valuable than businesses with a high degree of owner dependence. Business buyers want to acquire a company that can generate earnings for them in the future, not one that could only generate earnings for the departing seller.
Something everybody can recognize is a beloved long-time business that is overdue for new investment. The paint is peeling, literally and figuratively. The last marketing campaign was during the Cold War. Old equipment has been kept together with duct tape and a soon-retiring maintenance employee. The computer system was cutting-edge twenty years ago.
Such a business may continue to produce substantial earnings for its current owners. They may be debt-free and have intense loyalty among longtime customers. They know about every leak in the roof, and they can hear when the old machine is low on oil like a parent can sense when their child is ill without taking their temperature.
In other words, the business may not be particularly risky for the current owners because they have learned to manage its problems through decades of experience. But business value is not based on what the current owners can earn. A buyer has to consider what will happen after they take over.
Buyers of a business with deferred expenses may reduce their purchase offers by more than just the estimated cost of fixing the problems. The cost of upgrading to a modern computer system may be quoted, for example, but the cost and difficulty of integrating it with the rest of the business may be unknown. The cost of fixing the leaky roof may be known, but who knows what else will the contractor find once the work begins?
Because the current owner has not taken care of these expenses, the buyer is being asked to assume the risk that the eventual costs (not to mention time, effort, and stress of overseeing the improvements) will be higher than expected and future earnings will be lower than anticipated.
A familiar analogy is a homeowner trying to sell a house with an old roof or faulty air conditioner. The seller may be encouraged by their real estate agent to make the repairs before listing the home, because a potential buyer is likely to discount their offer by more than the quoted repair costs. The buyer is not only considering the cost of repairs; they are assessing the risk of unexpected problems.
The same principle applies to a business: deferred expenses are typically penalized by a reduction in value which is greater than the anticipated costs of remediation.
Revenue and earnings are important components of business value, but they do not tell the entire story. Two businesses with the same financial performance may have very different values because their likelihood of continuing that performance may be very different.
A professional business valuation considers both financial performance and the risks associated with producing those earnings in the future. Predictable revenue, a diversified customer base, experienced employees, limited owner dependence, and well-maintained business assets can all reduce risk for a buyer.
Customer concentration, owner dependence, deferred expenses, inconsistent earnings, and other uncertainties can increase the risk that historical performance will not continue under new ownership.
Business owners preparing for an eventual sale should therefore focus on more than their own top line and bottom line. Reducing unnecessary transfer risks can make a buyer more confident that the business will continue to perform after the acquisition. That confidence can translate into higher business value.
A business valuation can help identify which characteristics of a company are adding value and which are adding risk. Identifying those risks well before an ownership transition gives the current owner time to address them and potentially increase the value of the business.
Businesses are generally more valuable when buyers have confidence that earnings will continue after the current owner leaves. Predictable earnings, a diversified customer base, experienced employees, limited owner dependence, and well-maintained business assets can all reduce buyer risk and support higher business value.
Risk and business value generally have an inverse relationship. When buyers perceive greater uncertainty about future earnings, they will typically require a higher potential return and assign less value to the business. Reducing unnecessary business risks can therefore increase value.
High customer concentration can reduce business value because the loss of one major customer may have a significant impact on future earnings. All other factors being equal, buyers will generally prefer a business with revenue spread among a larger and more diversified customer base.
A business that depends heavily on the current owner's relationships, knowledge, or daily involvement may be more difficult to transfer to a new owner. This increases the risk that earnings will decline after a sale and may reduce the value of the business.
Yes. Business owners may be able to increase value by reducing risks before a sale. Developing management and employees, documenting important processes, diversifying customers, addressing deferred expenses, and transferring important relationships away from the owner can make future earnings more predictable for a buyer.