Key Financial Metrics

All business valuations are based on some measure of your business’s financial metrics. It’s wise to ensure your metrics are as healthy as possible before you begin the sale process. Doing so will make your business appear more attractive to potential buyers, no matter the buyer type.

Increase Profitability

The fastest way to improve the value of your business is to increase its EBITDA. Changes that don’t improve EBITDA have a less significant impact on your valuation than changes that immediately improve your EBITDA. One of the most effective methods for increasing profitability is to increase prices. One hundred percent of a price increase leads to an increase in EBITDA – minus direct costs, such as sales commissions. 

For example, suppose your business generates $10 million in revenue and $2 million in EBITDA and is valued at a 5.0 multiple, or $10 million. If you increase prices by 10%, your new EBITDA will be $3 million, and the value of your business will be $15 million ($3 million EBITDA x 5.0 = $15 million). In this case, a 10% price increase will result in a 50% ($5 million) increase in the value of your company. 

Test the elasticity of your pricing to determine the right pricing for your products and services. The entirety of a price increase falls to the bottom line, less any direct costs such as sales commissions, and an increase in profitability can dramatically improve the value of your business. 

Increase Revenue

Buyers look for businesses that have stable, upward trends. If revenue is increasing, buyers assume this trend will continue. If revenue is decreasing or inconsistent, buyers also assume the trend will continue and will view your business as risky. It’s best to sell your business when revenue is stable or growing. If your revenue is decreasing, create a plan and work to turn the trend around so you can reduce the perceived risk of your business to the buyer. If income is inconsistent, stabilize your revenue to ensure consistency from year to year. If you can’t turn the trend around, identify additional ways to increase sales and show these potential improvements to a buyer. At a minimum, you should prepare a plan and start implementing it. Progress on the plan will help inspire confidence in the buyer that the trend can be turned around.

Increase Recurring Revenue

If your business has recurring revenue, set up a dashboard to track metrics that impact recurring revenue, such as customer retention, customer churn, lifetime value (LTV), customer acquisition cost, months to recover customer acquisition cost, customer engagement, and leads by lifecycle. The majority of your key metrics will have an effect on your recurring revenue, either directly or indirectly, and tracking these metrics allows you to spot leaks in your funnel and plug them. Doing this also allows the buyer to understand how your business operates and the potential improvements they can make to increase the amount of recurring revenue.

Increase or Stabilize Margins

Buyers become concerned if gross margins have recently declined in your business. If this is the case, work to increase or stabilize them. Decreasing gross margins may indicate increased competition or an increase in your cost structure. If gross margins are decreasing, consider shifting revenue to a more profitable product line or develop a plan to stabilize them.

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. 

Reduce Expenses

Another effective method for increasing EBITDA is to reduce expenses. You should pinch every penny for two to three years prior to your planned exit to help maximize EBITDA. For every dollar in expenses you cut, not only will you save that dollar, but you’ll also receive a multiple of that total at the closing table based on the multiple you receive when you sell your business. 

If you cut expenses by $500,000 for two years before the sale and the sale process takes one year, for a total of three years, you’ll put an additional $3.5 million to $4 million in your pocket – $500,000 (year 1) + $500,000 (year 2) + $500,000 (year 3) + $2,000,000 to $2,500,000 (increased purchase price). 

Avoid making any large investments in your business, such as creating new products or services, or rolling out new sales or marketing campaigns that are high risk or that require significant up-front investments. These investments decrease profitability in the short term, which decreases the value of your business. If you do make a large investment, organize all expenses related to the investment under a separate chart or account so you can adjust these expenses in your financials when calculating EBITDA. Another option is to stick to low-risk strategies for increasing your profitability. 

As a general rule, you shouldn’t purchase new equipment or other hard assets when you’re in the process of selling your business unless it immediately increases your EBITDA. Why? Because you’re unlikely to recoup your investment. Buyers value businesses based on the EBITDA they generate. If the new equipment doesn’t increase your EBITDA, it likely won’t pay for itself. Most buyers in the middle market reduce their decision to a financial model, but these financial models don’t usually take into consideration the value of any new equipment in your business.

While the buyer may appreciate your investment in new equipment, they’re unlikely to assign enough value to it to justify your purchase. If the buyer is considering two similar businesses at the outset, the age and condition of the equipment will be one of dozens of factors they may take into consideration. Your business’s EBITDA will outshine most other factors, so make it your first priority. 

To illustrate this point, here’s a breakdown of the process of selling a business into two main steps: 

Step 1 – Attracting Buyers: This first step involves confidentially marketing your business for sale and responding to buyers who request additional information on your business. At the outset, buyers consider a limited amount of criteria when initially evaluating your business. At this stage, the main thing they look at is profitability. Few will consider the investments you’ve made in new equipment or other capital assets at this point in the transaction. In other words, investing in new equipment is unlikely to produce a higher response to your initial outreach. In this first step, those early criteria – your multiple, competitive advantage, and growth rate – are far more important to the buyer than your equipment or capital assets.

Step 2 – Convincing Buyers: After you’ve attracted a buyer and they’ve responded, you must now convince them to buy. The buyer will now consider a broader range of criteria once they’re inspecting your business more closely. This criteria may now include the current condition of your equipment. If a buyer doesn’t make it to this second step, your investment in new equipment is moot.

Most buyers’ main criteria is the cash flow, or EBITDA, your business generates. After all, buyers purchase businesses to make money, so their primary interest in buying a business is how much money a business makes. Anything you can do to increase EBITDA will have the greatest impact on the salability and value of your business. As a result, you should generally only buy new equipment if it immediately increases your EBITDA.

There are two scenarios in which an investment in equipment can increase your EBITDA:

  1. Increases Your Revenue: If the equipment or investment immediately increases your revenue, it may be a wise investment. This won’t be true in most cases, so it’s usually best to delay purchasing new equipment.
  2. Decreases Your Expenses: If the investment immediately reduces labor or other costs, it may be a wise investment. If the investment will increase the value of your business by more than the initial cost, the investment may be justified. To calculate how much the investment will increase the value of your business, simply multiply how much the equipment will reduce your labor costs by, then apply your multiple. For example, if the investment will reduce labor costs by $100,000 per year, and your multiple is 5.0, then the equipment will increase the value of your business by $500,000.

For example, let’s say you own a manufacturing plant and purchasing a new piece of equipment is estimated to improve productivity by 5%, which will reduce your payroll by $100,000 per year. Because of the new equipment, you may be able to receive an additional $500,000 for your business, assuming it sells for a 5.0 multiple ($100,000 increase in EBITDA x 5.0 = $500,000). Most buyers won’t be willing to pay you for 100% of the savings until they’re proven, so it’s best to assume you will only receive a portion of the credit for the savings. In this case, I wouldn’t recommend purchasing the piece of equipment unless it costs significantly less than $500,000 due to the risks involved in doing so. To find out, perform a calculation to see if the investment and the resulting increase in cash flow will have a positive ROI for you. 

If a new piece of equipment would simply be nice to have, or if it represents a new product or service line you could potentially pursue, I recommend holding off on the investment. Point out the opportunity to the buyer and let them decide if this is something they want to pursue and let them make the investment instead.

Reduce Working Capital

Most transactions in the middle market include working capital as a component of the purchase price. Working capital is calculated as accounts receivable, inventory, and prepaid expenses, minus accounts payable, short-term debt, and accrued expenses. 

Working capital is viewed by sophisticated investors as an asset that should be included in the purchase price. If you must keep a certain amount of working capital in your business, this is no different than any other piece of equipment, since the working capital must remain in your business as long as your business is operating. For example, if your business is valued at $5 million and it requires $500,000 in working capital to operate, most buyers will request that $500,000 in working capital be included in the purchase price. 

Which business would you rather buy?

  • Business A: Asking $14.0 million + $1 million required in working capital. Total investment = $15 million. Generates $3 million in EBITDA. Effective multiple is 5.0 ($15 million / $3 million = 5.0). The return on investment is 20%.
  • Business B: Asking $14.0 million + $4 million required in working capital. Generates $3 million in EBITDA. Effective multiple is 6.0 ($18 million / $3 million = 6.0). The return on investment is 16.6%.

All things being equal, nearly every buyer would rather purchase Business A because it generates a higher return on the investment due to its lower working capital requirement. Therefore, if you want to maximize your proceeds, minimize the amount of working capital required to operate your business. You can generally do this by keeping your accounts receivable and inventory levels as lean as possible. 

The two main components of working capital are as follows:

Component 1: Accounts Receivable

Because accounts receivable is included in the calculation of working capital, you can put more money in your pocket if you reduce your normal operating level of accounts receivable for at least 12 months prior to the closing. The primary method for reducing accounts receivable is to reduce the average number of days your accounts receivable are outstanding. 

Other tactics include: 

  • Writing off any bad debts that are old and uncollectible.
  • Invoicing customers in a timely manner.
  • Giving discounts to customers who pay early.

Also, if you consistently have late-paying customers, consider developing new collection procedures.

You should also formalize the terms you offer to customers. Businesses that offer terms to their customers are less desirable to buyers than businesses that don’t. Why? Businesses that offer terms have a longer cash conversion cycle and need more cash to grow the business. The shorter the cash flow cycle, the more desirable the business is because less working capital is necessary to scale it. Businesses with a long cash flow cycle require more working capital, and sophisticated buyers include the amount of working capital required to operate the business when calculating their return on investment.

Component 2: Inventory

In addition to accounts receivable, inventory is also included in the purchase price for mid-sized companies. By reducing the normal operating level of inventory in your business, you also have the potential to increase your net proceeds. The primary method for reducing inventory is by increasing your inventory turnover rate and moving to a lean, just-in-time system.

Inventory amounts vary from business to business, and changes in the value of inventory that’s included in the purchase price can significantly impact your net proceeds. Buyers consider any investments they must make in inventory when calculating their potential returns. If you have surplus inventory, look for creative ways to reduce it without impacting revenue, if that’s possible. 

Which of the following two businesses would you rather buy?

  • Business A: Asking $4 million + $100,000 in inventory. Generates $1 million in EBITDA. The effective multiple is 4.0. The return on investment is 24.39%.
  • Business B: Asking $4 million + $2 million in inventory. Generates $1 million in EBITDA. The effective multiple is 6.0. The return on investment is 16.66%.

Clearly, Business A is a more attractive investment because it requires less inventory to operate, and therefore generates a higher return on the capital invested. If you can, reduce the level of operating inventory necessary to operate your business prior to the sale.

Because you must include working capital in the purchase price of your business, it makes sense to reduce it as much as possible prior to the sale. For every dollar you decrease your working capital before the sale, you’ll put an extra dollar in your pocket at closing time. But the changes you implement to reduce working capital must be sustainable in the long term.

The fastest way to improve the value of your business is to increase its profitability. 

Action Steps

  • Increase Profitability: Focus on maximizing cash flow over other value drivers.
  • Increase Revenue: Focus on stabilizing or increasing revenue at least three years before beginning the sales process. Revenue should be on an upward trend prior to the sale. Consider increasing pricing to maximize revenue, which is the easiest way to increase sales.
  • Increase Recurring Revenue: Track your key metrics that affect recurring revenue and work to improve them over time.
  • Improve Margins: Stabilize or increase gross margins before the sale if they have decreased recently.
  • Cash Flow Cycle: Track your cash flow cycle and implement methods to reduce the total number of days of your cash flow cycle.
  • Capital Expenditures: Track your capital expenditures for five years prior to the sale and limit any capital investments you make in your business.
  • Decrease Expenses: Pinch every penny for two to three years before the sale to maximize EBITDA. Avoid incurring any discretionary expenses.
  • Decrease Working Capital: Focus on reducing the working capital requirements of your business by lowering normal operating levels of accounts receivable and inventory.