If you operate a business, you’ve invested the valuable resources of time and talent, and if you are a business owner, you have invested your hard-earned money. As both investor and investee, you should be doubly focused on increasing the value of your business and being a good steward of your resources.
Whether you plan to eventually sell the business or hope to hand the reins to the next generation, there are five key factors to keep in mind when considering the value of your business: revenue growth, profit margins, asset utilization, financing, and risk. While it takes all five to paint a complete picture, risk is most often overlooked. Higher risk businesses tend to sell for a lower multiple of earnings because the buyer wants a higher return.
What is risk?
Simply defined, risk is uncertainty. How predictable are the future revenues, profits, and cash flows of the business? Potential buyers normally look at historical business performance to make these predictions; one of the best indicators of the future, after all, could be the past. Wall Street analysts sometimes refer to earnings “quality,” or the ability to repeat or maintain the current level of earnings. If you plotted the annual revenue and earnings over the past few years from your business and the results look more like an EKG than a nice, steady incline, the risk alarms should be sounding.
So, what makes a risky business? And we aren’t talking Tom Cruise here. A few things to consider when it comes to minimizing risk…
All your eggs in one basket
Can you take a one month trip to Europe this summer and know that your business will continue operating effectively? If you get hit by a bus tomorrow, does the business continue operating? Personally, I prefer the trip to Europe, but the issue remains the same.
We all like to feel important, and for many businesses, so much is dependent upon the owner/operator or a key member of management. Unfortunately, this importance can actually reduce the value of the business. For example, if customers will only talk with the key person, how will a new business owner feel confident that customers will be retained?
One customer drives the train
Being dependent upon a key customer can be lucrative but dangerous, especially if the demands from this customer are growing. If you are increasing payroll, facilities, or other infrastructure to support a key customer, ask yourself what happens if and when you lose this customer. A potential buyer is going to want assurances that the key customer will remain with the business, and even those assurances may not minimize the perceived risk to a potential buyer.
Specializing in a very narrow product or service line can help your business stand out in the marketplace. However, while this may provide a competitive advantage, it can be dangerous to become too dependent on just one source of demand. If this line dries up, what alternatives does the business have? Perhaps some diversification through a complementary line can help reduce this risk.
The prudent buyer will ask the right questions to identify latent risks like key-person dependence, customer concentration, or lack of diversification. Therefore, it is important to evaluate and reduce these sorts of risks before you are put in the hot seat. An easy way to remember it: minimized risk = maximized value.
Source: Originally published in the July/August 2014 Golden Isles Magazine