Applying these practices to your business can help you close valuation gaps that may exist between how you value your company, and how a banker, buyer or investor analyzes and values your company. Ultimately, that higher valuation can mean lower cost credit, a better sale price or more favorable investment terms.
Have you ever heard the old adage that the best way to get a read on what someone is like or the quality of their character is to look at their five closest associates or friends? The same adage applies to how outsiders (namely investors, lenders or potential buyers) assess businesses. But instead of looking at friends and colleagues, we look at who that business has selected as their primary professional services providers (i.e., CPAs, attorneys, bankers, HR and payroll providers, and insurance and benefits firms).
The point is simple — professional services firms that work and consult with the leading companies in an industry will understand what those clients have done to be successful and will be able to apply that learning to provide more suggestions and partnership potential to your business. Other service providers may provide more customized attention for less money, but will offer fewer opportunities for your business to learn from peers through shared partners. Service providers offer immediate value in advice and consultation, and can also improve the soft components of your business’s valuation or credibility when looking to secure financing, sell or pass down a business.
Business owners should view the up-front $50,000 annual cost of an audit as a long-term investment that helps improve valuation rather than a “thing my bank makes me do to get a loan every year.” The latter view is both flawed and shortsighted when you consider the potential value missed.
Think of structure in a business less as “does my business have rigid protocols and procedures?” and more as “can my business survive without [name any key employee]?” Broadly speaking, highly valued businesses differentiate themselves by putting some form of management structure in place that is well known to the employees. This is important mostly for internal continuity of business, employee morale and clear delineation of decision-making in key areas of the business.
In the eyes of bankers, investors and potential buyers, a highly valued business has clear, diagrammed management team responsibilities with delegated authority. A delegated structure is important because it helps to minimize “key man” risks. Unfortunately, life is uncertain, and while a remote possibility that a key person leaves the company or is suddenly incapacitated may be a tough question to tackle, decision-making authority delegated throughout the business is key to ensuring business continuity if the unexpected happens.
Structure in business evolves over time, usually as a result of growth, but often commercial businesses or closely held businesses are slow to evolve their business structure because owners try to control too many elements in their business. It’s ironic, but typically some of the best running businesses and corporations have very few everyday operating decisions made from the top. So perhaps the key for business owners to achieve optimal valuations is to actually do less and rely more on the teams they built.
The core backbone of any business is its financial records since they are ultimately what valuations are based on. Exceptions occur in high-tech and other industries. Data and tracking may be the most difficult to implement. This is because a significant investment in technology and labor hours is typically required before you can institute actionable data-driven plans. In addition, it requires leadership within the businesses to change “well that’s how we’ve always done it” mentalities. Driving this kind of change is extra work, especially initially, but it’s well worth the effort in the long term.
Two of the most significant data and technology investments with the greatest ROI are accounting and
ERP (enterprise resource planning) systems. The timing of these investments is critical, because the larger a business grows the more difficult it is to change these systems. However, implementing a robust business software system too early can be uneconomical relative to the cost.
Additionally, a business’s books and records are the first things that outside capital providers look at to assess risks. Highly valued businesses understand this and make the investments in technology prior to growing and scaling.
Clear and accurate data about your financials, capacity, fulfillment and integrated sales pipelines enable decision makers to make smart investments in people and focused advertising. In addition, with enough historical datasets, the best businesses can begin predicting with higher effectiveness their short, intermediate and long-term sales and cash flows, allowing them to operate more effectively. Lastly, if you have a robust accounting and ERP system, it allows your CFO to focus on forward-looking initiatives and growth rather than simply keeping reporting accurate.
If you’re making decisions based on feeling and not data, chances are you’re falling behind the times and at some point it might diminish from valuation or cash flow.
When assessing lending risk, the businesses that have figured out how to automate processes effectively across all or most business disciplines are highly valued. These businesses recognize that while there is a direct cost in implementing process automation, they recapture the investment quickly.
Perhaps the most overlooked process automation opportunity is in managing cash flow. When they start, most businesses tend to send and receive payments the “old school” way, by check. As they grow, often their accounts payables and receivables processes don’t scale along with the company. When you add up how much these manual processes actually cost versus automated processes that accomplish the same tasks, it’s a substantial opportunity to save money and unlock cash that’s trapped in the balance sheet.
For example, if you’re paying all of your operating expenses by check, first you have to purchase the check stock. Let’s say that’s $200 per 1,000 checks. Then you need to pay for the ink at $15 per month for a volume of 500 checks per month, and postage of $0.55 per stamp. Layer in the employee cost, and you’ve got an additional cost of $81 assuming it takes nine hours per month to have an employee paid at $9 per hour handling your payables. When you summarize all of this together, it equates to an estimated $471 per month in pure overhead just to send payments to vendors or suppliers. Under the same 500 outbound payments per month scenario, let’s now assume an average cost per ACH of $0.45 and approximately three to four employee hours per month at $9 per hour. The effective total cost is $252 versus $471, a 46% real cost savings. This example is just on the payments side; there are many ways to automate and speed up and/or extend payments and collections to optimize cash flows and unlock working capital.
What highly valued companies do differently is partner with a working capital specialist to develop customized solutions to automate these processes, and continue that partnership as the business evolves.
Now, let’s talk about growth…one thing that typically unites business owners of companies of all sizes is their passion for growth. For many business owners and sales organizations, the focus is often on top-line sales revenue. Revenue is obviously important, but it’s not the answer to every problem. Ironically, explosive growth is the business “event” which puts more companies in trouble than any other. Usually it’s because there is a lack of working capital in the business.
The most common practice of highly valued companies is to track and think strategically about improving margins, and incentivize the sales organization based on margins. Margin is tough to fully understand without the appropriate accounting platform because fulfillment times, inventory turnover, collections and volume are all important factors. If you don’t know what you are making on the sale of a particular product or service, how can you appropriately budget your costs as your business grows? This is why it is so important to look at the whole picture before assuming that revenue growth is the cure to all business problems. If you’re not sure of where to start, there are hundreds of books worth the read that take a quantitative approach to helping you solve this problem.
It is very rare to find businesses that struggle in the long term when their sales teams are appropriately incentivized according to net profits or gross margins. By aligning sales leaders with the goal of profits, you eliminate the single biggest point of potential for conflict between business owners and employees that commonly exists. Furthermore, this incentive structure can help you recruit better salespeople. Overnight you shift your product sales pitch from “price” driven to “value/service” driven.
Of course there are still some pitfalls to a margin-based incentive model with price gouging as the biggest risk. However, this risk is mitigated by putting internal controls and pricing scales around products or services to ensure you deliver a consistent message to your consumers.
There are many practices that differentiate highly valued companies. Ultimately, there's no right or wrong way to ensure an outsider's valuation matches your own, but implementing these best practices could potentially result in a significant valuation increase compared to the costs.
Our deeply experienced bankers are well-versed in the business practices that affect business valuations. Our bankers recognize that these changes don't happen overnight, but they specialize in helping businesses achieve their full potential through a strategic consultative process. Plus, our network is your network; we're always happy to connect our clients with contacts within our network who have expertise on a particular topic, or who have overcome similar challenges.
contact a Texas Capital Bank relationship manager.