In today’s environment, it’s important for business owners to focus on the value of their company and what drives it. The objective of this article is to look at value drivers for operating businesses, as opposed to businesses that are asset-based, such as real estate or securities holding companies.
Under the market and income approaches, operating businesses are valued based on how much cash flow they’re expected to generate in the future. In other words, cash flow drives value.
If you want to increase value, you need to increase sustainable cash flow. Notice, we said the sustainable cash flow. While it might look good to have a short-term increase, an educated buyer will see through any non-sustainable increases and adjust those in determining the purchase price.
Here are some tips on ways to dress up the company for sale and increase sustainable cash flow at the same time:
1. Adjust compensation to a level that is representative of what an independent owner, not active in the business, could expect. If a business owner is deriving a living from the business, as many are, then he or she might find other ways to receive the same cash flow. If a business is a pass through entity — such as an S Corp, LLC, LLP or partnership — then perhaps the operator-owner can use distributions to owners as a method of extracting cash from the business.
2. Adjust business expenses to a level that would be anticipated by an independent owner. There are two ways:
- Eliminate any “perk” expenses that owners and executives might be taking out of the business. These are expenses that an independent owner would not expect to pay unrelated executives or employees. Once again, owners can use distributions, instead of these “perks,” to get cash in their pockets. The trade-off for increasing the value of the business is that taxable income (and, therefore, tax obligations) will be higher, however.
- Also analyze the company’s expenses from top to bottom and eliminate items that are not essential to the company’s operations. Most companies find that there is fat to trim. This does not mean that expenses should be cut to a point where efficiency and employee morale are affected. However, if a company has not done a cost study recently, it can be an effective way to increase value.
3. Increase revenues. This is often easier said than done. But for established “cash cow” businesses that have been relying on established customer relationships, it may have been a while since they’ve focused on selling new business. Don’t rest on your laurels as you start thinking about retirement — it could substantially reduce the price your business will fetch in the marketplace.
4. Review all policies, procedures, processes, contracts and agreements. Although this isn’t directly related to increasing cash flows, a buyer expects to see all of these things in good shape during the due diligence process. Assembling an organized “offering package” can increase the value of the company and expedite the selling process. Here’s a quick list of some items to consider for review:
- Real estate and equipment rental agreements,
- Employment and noncompete agreements,
- Supplier agreements,
- Customer contracts and lists,
- Insurance policies, including company-owned key person life insurance plans,
- Mortgages, lines of credit and other financing agreements,
- Fixed asset listing,
- Technology inventory and licenses,
- Brochures, catalogs, websites and other marketing programs,
- Job descriptions,
- Formal policies and procedures manual, and
- Organizational charts.
There are many other things that can be done to help increase the value of a business. This article outlines some of the lower hanging fruit. Contact your CPA for assistance in getting your business ready for sale. He or she may have some creative ideas that relate specifically to your business.