Financial Factors

Your business’s finances are one of the first things any buyer will examine. How does your company’s financial performance compare with its peers? The stronger your financial metrics are compared with others in your industry, the more your business is worth, provided your metrics are sustainable in the long term. It’s crucial your finances are in order if you want to maximize the value of your business. 

Revenue

If revenue from your business is trending higher, this enhances its value. Buyers generally assume that financial trends will continue in a business if all signs point in the same direction. As a result, revenue trends are of particular importance to buyers and can have a significant impact on your company’s value. If revenue growth is consistent for your business, this reduces the perceived risk for a buyer, which increases value. 

What are the growth prospects for your company? The higher the growth potential and prospects, the more your business will be worth. On the other hand, if the revenue from your business recently declined, buyers will consider this excessively risky. If revenue growth is inconsistent for your business, this increases the perceived risk for a buyer. Inconsistent revenue is viewed as risky by most buyers and will always result in a lower valuation.

Margins

Are gross profit margins holding steady, increasing, or decreasing? How do your gross margins compare to your industry’s benchmarks? Strong gross margins improve your business’s value, especially if your lower cost structure is sustainable and your margins are consistent from year to year. If gross margins are low for your business compared with others in your industry, this will decrease its marketability and, hence, its value.

Profitability

If your company generates a limited amount of EBITDA, your business will be difficult to sell. Buyers compare an investment in your business to alternatives. If the cash flow from your business is less than that of more attractive alternatives, there needs to be a significant upside to attract interest.

Consistent earnings in your business reduce its risk and improve both its marketability and value. If earnings from your business are inconsistent, most buyers will consider this risky, which will result in a lower valuation.

EBITDA is the starting point of nearly all negotiations for middle-market transactions. For most industries, EBITDA multiples are fairly predictable, and acquirers rarely stray from prevailing industry multiples. For example, if your company generates $3 million in EBITDA, most buyers will value your business at 4.0 to 7.0 times your EBITDA, or $12 million to $21 million. 

How does a buyer determine where in the range you fall? 

It’s simple – they consider all the factors other than EBITDA. In other words, nearly every buyer will initially establish a baseline value based on a multiple of your EBITDA, and then increase or decrease the price they’re willing to offer within that range based on all other factors. The higher your EBITDA, the higher the baseline value of your company. 

EBITDA is the starting point of nearly all negotiations for middle-market transactions.

Recurring Revenue

If your business generates recurring revenue, this improves scalability and reduces risk. Contractually recurring revenue is the number one value driver for many industries, such as software and tech. There’s a reason the so-called subscription economy is expected to reach $1.5 trillion by 2025, according to UBS Wealth Management, more than double the amount at the start of the decade. Recurring revenue is viewed as more valuable than income generated from new sales. Buyers are willing to pay significantly more for a business that generates recurring revenue as opposed to revenue generated from drumming up new customers.

Examples of companies with recurring revenue include:

• Netflix: Monthly subscription fee
• Spotify: Monthly subscription fee
• Apple: Recurring subscription fees for Apple Music, iCloud, and more
• Accounting Software: Subscription fees for QuickBooks, Xero, and others
• Web Hosting: Subscription fees for GoDaddy, Bluehost, and other services
• Microsoft: Recurring subscription fees for Office 365, and other programs

There’s a difference between recurring and repeat revenue. While it’s good to have repeat revenue, it’s an unpredictable form of income. Recurring revenue is predictable because it’s usually auto-debited from the user’s credit or debit card on a regular schedule, such as with cell phone bills, gym memberships, or various online services.

If your business doesn’t generate recurring revenue, this limits scalability and increases risk. Recurring revenue is more predictable and results in a higher customer lifetime value than non-recurring revenue. The higher the lifetime value, the more a company can afford to invest in acquiring customers, the more scalable the business is, and the higher its valuation.

Then there’s the matter of customer retention. If your business suffers from high attrition, which could be due to high customer churn, your business will have a difficult time scaling. Poor retention can be caused by a number of issues, from product features to the overall user experience. 

Recurring revenue is viewed as less risky by acquirers than forecasted revenue based on new product sales, which buyers heavily discount. If the revenue isn’t contracted, the owners may leave and take their relationships with them, or customers can leave during the transition phase due to the uncertainty an acquisition creates in the mind of the marketplace. As a result, contractually recurring revenue is the gold standard when buying and selling a business. It’s no coincidence that even sales of non-traditional subscription items such as vitamins and pet food have grown so much in recent years. 

Contracts ensure retention and offer the acquirer enough time to build trust with the customer post-closing. This means that businesses with contractually recurring revenue will sell at higher multiples than those with non-contracted revenue. A bird in the hand truly can be worth two in the bush.

Cash Flow Cycle

The cash flow cycle is the amount of time it takes to convert a sale to cash. Highly scalable companies have a short cash flow cycle and, therefore, a higher value. The shorter your cash flow cycle, the more scalable your business will be. For example, if your business offers no or minimal terms to customers, this shortens the cash flow cycle, thereby improving its scalability and reducing risk. If your cash flow cycle is long, a buyer must make a significant investment in working capital if they want to grow your business quickly. As a result, they often include a deduction for an increase in working capital, which decreases cash flow and, subsequently, the value of your business.

If your business offers significant terms to customers, this increases the cash flow cycle, which reduces scalability and increases risk. Has your business loosened terms to boost revenue in the short term? If so, this revenue will be discounted by buyers.

Likewise, if you carry significant inventory levels, sell customized products, or offer your customers terms, your sales cycle may be extended. A long cash flow cycle limits the scalability of your business and requires the buyer to make large working capital injections to fund future growth. Both factors drive down the value of your business.

Working Capital Requirements

If your business requires a lower-than-average amount of working capital, your company’s ROI and value will increase for the buyer. Nearly all buyers in the middle market make an offer that includes a set amount of working capital in the purchase price. Working capital is calculated as accounts receivable, inventory, and prepaid expenses, minus accounts payable, short-term debt, and accrued expenses. If your business needs a high amount of working capital, this must be factored into the purchase price, decreasing your net proceeds. 

Most buyers factor the amount of working capital required to operate the business into the total investment to calculate the multiple. 

For example, if cash flow from your business is $5 million per year and your business is valued at a 6.0 multiple, your business will be priced at $30 million ($5 million x 6.0 = $30 million). But if your business requires $5 million in working capital (total purchase price = $30 million + $5 million = $35 million), then your multiplier will be 7.0 ($35 million / $5 million = 7.0) if working capital is included in the calculation. 

If your business requires a lower-than-average amount of working capital, your company’s ROI and value will increase for the buyer. 

Capital Expenditures

Capital expenditures, or CapEx for short, are investments made in capital equipment and other fixed assets. Capital equipment is depreciated because it’s expected to have a useful life longer than 12 months. While depreciation is added back when calculating EBITDA, some buyers subtract a reserve for capital expenditures when valuing your business. A low CapEx makes your business more attractive to most buyers. Carefully track your capital expenditures for five years prior to a sale, and be as frugal as possible with any capital investments you make in your business. 

If your business requires lower-than-average CapEx, this is a positive attribute for buyers because it will require less capital to sustain or grow operations. Some buyers subtract a CapEx reserve from EBITDA before valuing a business. Low CapEx – a hallmark of any acquisition targeted by legendary investor Warren Buffett – makes your business more attractive to sophisticated buyers. High CapEx makes your business less attractive.

Quality of Financial Records

Take a close look at your financial records and consider the following questions:

• Are they accurate? 
• Do your tax returns match your financial statements? 
• Are your financial statements clearly presented? 
• Do you have strong accounting controls in place? 
• Is your business using the last in, first out (LIFO), or first in, first out (FIFO) accounting method, or some other form of inventory accounting? If so, how has this affected your earnings? 
• Have you properly recorded inventory, or have you under- or overstated inventory in an attempt to manipulate earnings?
• Are your financial statements prepared on a cash or accrual basis? If the latter, are the accruals being correctly done?

The stronger your financial statements, the less risk buyers will perceive, and the more they may be willing to pay for your business.