Table of Contents
- Bookkeeping Practices
- Receivables Management
- Inventory Management
- Management Awareness
- Capital Expenditures
- Diverse Client Base
- Diverse Product Offering
- Physical Plant
- Growth Story
- Risk Management
1. Good Bookkeeping Practices.
A valuation is based upon quantitative and qualitative analysis. The quantitative element is based upon financial statements provided by company management and reflects at least five years of past performance when available. The accuracy and clarity of the statements will show the analyst how well the company has performed as well as how the company paid attention to this crucial element of business operations. If the books are in bad shape or were thrown together to facilitate the valuation, the value will suffer through an increased risk metric. To avoid this and to increase the value, the firm should keep accurate records of performance by taking the time and spending the money to establish and maintain good books and records. While this seems elementary to practicing business attorneys, it is not a practice that is universally applied in the small business community. In many cases records are haphazard or non-existent. This impairs management’s ability to make informed decisions about the future financial direction of the business and will negatively affect the final valuation when the time comes to sell the business. There is no good reason NOT to keep good books and records and there is every reason, including a higher valuation, to do so.
2. Receivables Management
We all cling to the hope that we will actually get paid on a receivable over 120 days old, but the evidence of doing so is against us. Allowing receivables to age to that degree shows inattention to financial management and perhaps a faulty billing, invoicing and collection system. This hurts valuation in several ways, first by reducing cash flow, which is a vital component of firm value and second by showing the analyst that insufficient attention is paid to important firm matters. Receivables management should reflect a written company policy regarding extension of credit and aggressive methods of invoicing and collection. Sending invoices every six months is simply unacceptable and will result in skewing the aging schedule in the wrong direction. The valuation analyst will consider this as an added element to risk and reduce the final valuation accordingly. Conversely, a well written plan to reduce receivables by converting them to cash and evidence of compliance with the plan will enhance cash flow and enable the company to reduce debt, pay its taxes on time and to take advantage of positive net present value projects as they arise. A company with its money tied up in 120-day old receivables presents much more risk and will have a lower valuation.
While it may be a comfort to see all those receivables on our balance sheet, the fact is that they are costly to try to recover and costly in terms of lost cash flow.
“Receivables management should reflect a written company policy regarding extension of credit and aggressive methods of invoicing and collection.”
3. Inventory Management
Imagine a company with a warehouse full of eight track tape players holding on to them in the hopes of a big sale. Seems silly, but it happens. Old and stale inventory should be treated as such. Also, many firms keep no inventory records at all but simply stack the stuff on shelves or in a back room. As with receivables management, there are several reasons why inventory management is so important. First is that inventory is very expensive. It must be purchased, stored and insured. Hopefully one day it will be sold or used, but let’s be realistic. If it has outlived its value to the company, take steps to get it off the books and onto the table at a garage sale. Clutter of old and useless inventory will reduce value by adding unnecessary costs and taking up valuable space.
4. Management Awareness of Industry
A comprehensive valuation will include interviews with ownership, management, staff and line employees. In most cases management and ownership will be the same people or person. Discussions with management will show how familiar it is with the industry, the market and the prospects for the company within that industry. A manager that can intelligently discuss trends and developments, present and future markets, costs, risks and competition will enhance the final valuation.
5. Detailed Capital Expenditure Program
Future capital expenditures are essential to growth and increased profitability. New equipment, technology upgrades, cyber security investments, physical plant improvements, new locations, opening of new markets are all important and legitimate uses of earnings. Management should be able to articulate costs and benefits of each capital initiative. Simply saying “We’ll spend $500,000 on new equipment next year” does not give the analyst sufficient information to incorporate capital expenditures into the numerical analysis. A comprehensive plan for new equipment would include specific equipment, price estimates, transportation and training costs and potential benefits. Also, by planning and accurately projecting capital costs and benefits, the company will have a benchmark to gauge performance.
6. Diversify your Client or Customer Base
A company with a two large clients is one letter away from going out of business. On the other hand, a company with a hundred smaller clients has some protection against losing one. Valuation analysts will examine the breadth and loyalty of the customer base. They will determine whether there is risk involved in loss of clients and whether existing clients provide repeat business. A company with many clients who provide sustainable repeat business will receive a higher valuation than one for whom a loss of a single client represents a substantial part of their business. The same goes for vendors. A business with a single vendor is at their mercy regarding price increases and delivery slowdowns. Businesses should have existing relationships with many suppliers to provide a backup if one is unable to perform up the demands of the company. Diversification can also involve markets in different geographic regions. By expanding the geographic scope of the market, a business can reduce its risk and increase its value.
It is well recognized that smaller companies are a greater risk than larger ones, which is why they often have better returns in the public markets. The risk of smaller companies is that they have a narrower customer base and limited geographic influence. The analyst will take all this into consideration and impose a higher risk metric unless management has taken active steps to broaden the base and area.
7. Diversify Your Product Offering
Offering a single or limited number of products or services can hurt your valuation. A lawyer that handles only bankruptcies will experience hard times when the economy is good and bankruptcies are few. Analysts will look for product diversification as a measure of risk when a single product falls out of favor or is found defective.
8. Physical Plant
The valuation analyst will likely pay a visit to the site of the business being valued. During the visit the analyst will interview management, staff and employees. The analyst will also look at the physical plant to determine the condition on the valuation date and the need for a new paint job or upgrades to outdated equipment and to the general condition of the fixed assets. If management claims that there is no budget for plant improvements, yet the current shape of the plant is less than stellar, the analyst may include a provision for capital expenditures in the valuation spreadsheet. This will reduce the resulting valuation.
Prior to the visit, management should look at the plant and take steps to improve the appearance and condition of the assets. It need not be a complete overhaul, simply a good cleaning and de-cluttering. Old files, paperwork, newspapers, ten-year old invoices have their proper place and sitting on a desk is not one of them. This all detracts from the impression of the physical plant. Take the time to give an appearance upgrade. It will pay off when the valuation is complete.
9. A Good Growth Story
A business that doesn’t grow doesn’t prosper. Prospects for future growth are a crucial aspect of the valuation. Management should formulate and implement viable and achievable growth targets and should be able to articulate these plans to the analyst. The growth metric, when considered in perpetuity can have an outsized effect on valuation. Growth stories should be realistic and detailed enough to convince the analyst that better times are on their way. Five years of flat income with no hint of growth in the coming five years will hurt that final number.
10. Solid Risk Management Policies
Along with growth, the level of risk associated with a company will have a substantial effect on value. Risk management could be anything from theft control, to cash management, to insurance, to environmental compliance and to safety in the physical plant. A violation of any of the above can result in unnecessary outlays of scarce resources, the scarcest being cash. Companies should examine where their risks are and implement policies to mitigate risk where possible and shift it where it is not. Risk management procedures will be a subject of analysis with the valuator. Time spent analyzing these issues prior to the valuation will benefit everyone, management and staff alike.
In summary, the valuation analyst will examine a lot more than financial statements when compiling her report. Financial statements do provide valuable insight into the performance of the company and the future prospects for growth and profitability. However, this is just the beginning. There are many subjective elements to the valuation, elements over which company management has significant control and which will significantly affect the final result.
This flyer discusses only ten of the more common areas for discussion and investigation but there are many more. A company owner seeking the highest valuation should be sure to cover the ten above and then to expand the effort to address other risk factors, growth factors and income levels. A good brainstorming session with senior staff and line employees may root out problems that can be solved prior to the valuation. By doing so, company owners can ensure the highest valuation considering all facts and circumstances. Finally, it should be noted that all the above referenced steps are recommended for any business, whether under valuation or not. Good bookkeeping, a solid growth posture, effective risk management, knowledge of the industry and a diverse client and vendor base are an excellent foundation for building a successful business.
Behind every business there is a story worth knowing. In many cases this will enhance business value and contribute to future profitability and success. It is up to management to tell that story efficiently and convincingly.