How attractive is your business?

Over a year ago we started this column with the idea of helping entrepreneurs understand more about what drives value in a business and how to influence this so as to build a more valuable business.

To recap, the value of a business today is based on its expected future returns (free cash flow generation) discounted by the amount of risk to the capital employed in the business.

A business sources capital from equity investors and by borrowing money (debt) from lenders like banks, so in valuation calculations we discount future cash flows by the Weighted Average Cost of Capital (WACC). This is the after tax cost of debt multiplied by its proportion of capital employed, added to the cost of equity multiplied by its proportion of capital employed.

Generally, any debt is secured against an asset and is repaid from profits before tax. Then taxes are paid and only afterwards does any surplus get passed on to the equity investors.

Likewise, if the business runs into trouble and is liquidated, the equity investors are the last to get any money out – they only get paid once everyone else has been paid.

So what this means is that the cost of equity capital is highest because its at the greatest risk. The cost of debt is the amount your commercial bank charges you on loans longer than a year. It’s easy to calculate – just read your bank statement.

So how do you calculate the cost of Equity capital?

It’s not easy. Even for big listed companies, you need to look at how the business tracks the index, the index tracks the market, the market tracks the global economy and then relate this all back to long-term treasury bond interest rates in the USA. There are fancy words we use in Finance like Beta and synthetic Beta, and a whole bunch of mathematical formulas used to calculate them.

What’s hard to get right in big listed companies becomes impractical in the SMB market, so for SMBs the approach taken is one of two: either the equity investor says ‘I need a return of at least 30% in my fund, so let me discount by that amount and see if the number remains positive’, or the private investor says ‘given what I know about the risk of the business I want a return of 20% on my money, so let me discount by that amount and see if the number is positive’. In both cases these are very subjective numbers, whose practical application is limited really to large funds and experienced investors.

So how can you determine the appropriate cost of equity capital for your business?

Well, over the past 16+ months we’ve been working on scoring risks in a business and trying to come up with an appropriate cost of equity that you can use in Valuations. We’ve been looking for a way to do this that offers not only a reliable estimate for any SMB that uses it, but also allows a bigger fund or investor to compare risk and costs of equity across several businesses, even those that operate in different industries around the world.

So what we’ve developed is a survey tool. We call it the ‘Business Attractiveness Survey’ because it’s about the future and strategy as well as being about risk. The survey takes about 15 minutes to complete, is dead easy for a business owner to do, and the results are entirely free. The results include an overall risk score for your business (compared to its industry peers) and a suggested cost of equity capital that you can use in your own valuation calculations/investment decisions.

All you need to do is go to www.valuationup.com, register, add your business and start answering the questions. Your results are confidential (others you add in your business will see them, outsiders wont). If you invite others from your industry – your customers and suppliers, even your competitors, you’ll get to see how your risk compares to the industry average (and how your suggested cost of equity compares to the industry average).

Over time, we hope to build up a ‘Zeitgeist’ of each industry in each country, including commentary from business owners around specific risks, trends or opportunities. We’ll share interesting information here and in our blog as it becomes available.

How risky is your business? What returns should you be looking for on your equity capital given this risk? Where should you focus efforts to lower risk and increase your valuation? Find out for free on ValuationUp.com.

Things to do before you sell (continued).

Selling your business is when things hopefully come together for you: all the hard work over the years is rewarded – you get a lump of cash and ride off into the sunset. At this, this should happen if you’ve done all the homework and made your business as saleable as possible. In this article we continue to look at some of the things you need to do before you sell.

Reduce risk, especially concentration:

 

Most SMBs suffer from concentration risk, particularly in the areas of suppliers, customers and product line. A business that has a great relationship with their sole supplier for 5 years might think they’re doing fine, but they quickly learn the opposite when the supplier changes terms, licenses a competitor, is bought, or goes under. Having only a few customers or selling only a few products carries similar risk: things change, relationships change and when they do your ability to price often goes out the window and the value of your business does with it. So a key step in preparing your business for sale is to reduce concentration risk in these three areas. Actively seek out alternate sources of supply. Make sure you have several suppliers who you can buy from. Actively seek out new customers, and diversify your product range. It’s highly unlikely that you’ll be attractive to a buyer unless these risks are already diversified.

Make your revenue predictable:

You want to make your business into a money making machine. You must get to the point where you know that if you invest $100 today it should spit out $150 or more in a few days/weeks time. Then you can make a call as to how much you invest now and how much of return you expect in what timeframe. More importantly, the buyer of your business can see this too and will quickly understand the opportunity. To get this in place you need to invest in marketing systems: identify your target market; understand how they buy and how they make purchase decisions. Make sure you tick off each box. Show what campaigns you’ve tried and what their success rate has been. Track the entire sales process, gather feedback along the way and ensure you know your Net Promoter Score. These systems all take time and patience to set up, but they’ll give you a far better idea of whether you should be selling your business at all, and if you still decide to, it will help a buyer understand the value of what they’re buying.

Remember that the buyer has many choices, but so do you:

If you want to sell your business you need to standout from the others that are also for sale, and there are many. Luckily most of them are really not worth much, so if your business is well run, if the sale is well packaged and presented, and if you’re not in a rush to sell then you’ll immediately be in the top 5%. The buyer will hopefully have looked around and decided that your business is the one, but more likely they’ll be cheeky with asking price and back off unless convinced they’re getting a bargain. If you’ve done your homework, and taking the effort to a proper DCF valuation then you’ll easily understand whether it makes sense to take a particular offer or keep the business because you’ll know what it’s worth to you in cash terms. You’ll also be able to show this to a buyer to justify your price. Preparing early and properly are key steps towards keeping your options open and making the purchase of your business the only really good option for the buyer.

Selling to a strategic buyer v financial buyer:

You’ll almost always make more money and sell your business in less time, by selling to someone in your industry (or one adjacent to it) than a purely financial buyer. The reason has to do with both better understanding of the business by the buyer (i.e. they more accurately price the risks involved because they know them already) and that an industry buyer can probably reduce costs by sharing sales efforts, distribution facilities or some other cost with their existing business. The corollary to this is that an industry buyer will probably already know if your business is a good one or not. They will have been your customer, supplier or competitor for years. This is how ‘walk in sales’ happen: an industry player arrives at your door one day and asks if your business is for sale, entirely out of the blue. What this means is that you should always be ready to sell and have an idea of how much your business is worth.

Document in advance:

Well-run businesses sell more easily than poorly run businesses, for obvious reasons. A well-run business will have systems in place and its documents in order. So, you need to get your records together long before you plan to sell. Show monthly management accounts, board meeting minutes, marketing plans and results. Employment contracts, annual regulatory returns, tax clearances, contracts and insurances. Including your lease and escalation terms. Key employment contracts, disciplinary notices etc. Get everything in order. Put physical copies in a nice big file. Or preferably scan anything physical and store digital copies somewhere – these are far easier to share with prospective buyers and you’re less at risk from someone losing the file. Getting this stuff together in advance will make you better run, and it will also make you better run. You’ll be able to answer any question about the business almost immediately too, which itself makes the business more attractive.

Get a regular, independent valuation of your business:

Research shows that businesses that have been independently valued sell far faster – the reason for this is that the price is more realistic from the start, and also that a skilled, qualified person has cast their eye over the business already. The other main reason to get a regular valuation is that the Discounted Cash Flow value of your firm is an important target against which you can incentivise staff and deploy resources. The result is that they are shooting in the dark, under-perform and achieve lower selling prices as a result.

Consider these things before you sell you business

Selling your business is potentially the most important thing you’ll ever do and hopefully will be the moment when you realise great financial returns from your efforts over the years. It’s the time when you actually make money from all the hard work that’s gone into building the business over the previous years.

The trick is not to mess it up: selling a business is a complex process with many moving parts and it frequently goes sour, mainly due to the unpreparedness or unreasonable expectations of the seller.

This article is part 1 of 2 that aims to briefly cover the most common mistakes sellers make, and show you how best to prepare your business so that it’s attractive to the right buyer when you’re ready to sell.

Shift happens: always be ready to sell:

In the ideal world we build a business over a period of several years and plan to sell it at a certain milestone: normally the age of the owner, a valuation target, or a certain profit target. The hard fact of owning a business is that accidents happen and people (business owners or major shareholders) are disabled or die. The other thing that happens (albeit less frequently) is that someone walks off the street and asks to buy your business. Either way, you need to be prepared to sell your business at any time, and you need to make sure that your business can be sold even if you’re the one who is dead or disabled. Life happens. Death happens. Make sure the assets of your loved ones are secured by preparing your business for sale and also making sure that you carry key-man insurance so that if any major shareholder dies the business can buy them out.

Transactions cost you time and money:

Selling a business, buying a business, or raising capital can be very expensive transactions. They take time away from running the business and also cost money in terms of specialist advisors who are there to make money by guiding you through a process and other transaction fees as money actually changes hands. The advisors will cost more money if you are unprepared simply because there is more work for them to do and you will also not know enough to stop being taken advantage of. The more preparation you can do in advance the lower your transaction costs will be both in terms of distractions and advisory fees paid. From an advisory perspective, the amount of work done to conclude a deal in the $1M range is not very different to that of a $100M deal, so advisors will charge a much higher percentage fee for smaller deals. Research I’ve seen suggests that smaller businesses pay total transaction costs of up to 25% of the deal, for deals under $500K, whereas total costs on a $100M deal are more likely 2%.

An independent valuation serves as a guide, but it’s different to price:

The goal of an independent valuation is to determine the price at which a business would change hands in a free and fair market, where a deal is concluded by a motivated buyer and a motivated seller with all facts about the business known to each party. The calculations that go into an independent valuation are useful, and it’s good to always know the current valuation of your business and use valuation as a long-term management metric. However, the actual price you get will depend on negotiation. The best possible position you as a seller can be in is where you don’t have to sell the business and probably don’t actually want to, yet have several competing parties bidding for your business. Most sales are concluded in less than ideal conditions – the business needs capital investment, the owners want to retire, someone is ill, etc. In most times this lack of preparedness leads to a buyers market, but it doesn’t have to be the case – you just need to treat your business and investment.

Treat your business as an investment from the start:

The value of a business to you is the value of the cash flows you expect it to generate for you (through dividends, expenses that it covers, or excess owners income) discounted back to today by a factor that accounts for the risk to the capital used to generate those returns. The trick to getting a fair price for your business when you come to sell it is in being able to compare how its risk/reward combination compares to other investment choices you have, or your buyer has. If you’ve treated your business as an investment from the start, then hopefully you’ve taken every step to increase returns and reduce risks. This includes employing a suitable manager and paying him/her the market rate (or paying yourself the market rate if you are that manager too). What this means is that when someone offers you X for your business, you’ll be in a immediate position to know if that deal makes sense or not. Alternatively, if a buyer asks you to justify the price you want you’ll be able to show them how your business offers better returns for less risk that other’s they’re looking at, and is thus worth more. Sadly, if you don’t treat your business as an investment then odds are that you’re not managing it like one, and when it comes to sell you wont see investment-grade returns. You’ll be lumped with the majority of naïve foolish entrepreneurs who accept a multiple of 3x PAT when you could make far more by showing the buyer how much cash your business generates and what that’s worth now.

We’ll cover another 5 tips in next weeks article. Don’t sell before then!

Race pace

Start-ups are incredibly hard. Paul Graham, the legendary investor behind Y-Combinator says of start-ups: “Everyone is surprised by how difficult it turns out to be, because it’s not the kind of difficulty people have experienced before…Nobody knows what they’re capable of until they try it. Maybe half a percent of people have the brains and sheer determination to do this kind of thing. Start-ups are hard but doable, in the way that running a five-minute mile is hard but doable.”

I really like this analogy; the “5 minute mile”. It speaks of the pace necessary to achieve top performance.

As a former international rower (think Oxford/Cambridge, not the Dusi), I used to spend many hours analysing video footage of the top international teams racing. The impression I had of the medal winners was always how absolutely smooth and effortless they made things look, even though I knew that their muscles were burning and they were so starved of oxygen that they were close to blacking out. You’d see these top teams racing to the line, absolutely expressionless and perfectly synchronised, yet going through hell inside. The finish-hooter would sound and in that instant all composure would end – they’d collapse, spent, gasping, faces contorted in pain as the expense of the last 6 minutes of sprinting was allowed to show. The lesson was that these athletes won their races because they were able to relax at speed. They were simply better at being fast than the others around them. The many year of training it takes on top of natural talent helps the body become incredibly efficient and the mind to learn to keep critical control when all systems want to stop. It’s a lesson that applies to business just as much as it does to sport.

There is a pace and a flow to business. Many years ago a VC friend of mine said that there was “a time to walk, and a time to run”. Sometimes you had to chase deals aggressively and run like crazy. Other times the pace was slow and you couldn’t force it. My friends’ lesson was that there was no point running in a ‘walking time’ and no point walking when it was time to run. You’ll waste a lot of effort if you get this wrong – and its’ been an important lesson that’s stuck with me over the past decade. I use this in prioritisation – doing chores when its slow and chasing deals when its time to run. Critical bugs get fixed immediately, and then the pace changes to the more methodological work of adding or improving features. Chores get done because they’re important, not urgent.

In my daily life working closely with software development teams, we follow an agile development process: we break work down into 2 weeks units called ‘Sprints’. The rough idea is that we get measurable progress every 2 weeks and can re-prioritise frequently. When we started this way of work a few years ago it would feel like we were running hard for 2 weeks only to run hard for the next 2 and so on. We were always sprinting, but business is a marathon, right? Sure we have to be very careful of burning out?

The answer lies in what it takes to be world class: A world-class marathoner will run the full 42.2Km at a pace that is faster than most of us could sprint. If you look at top marathoners, they run at a pace that is about 5 minutes per mile. If you watch them racing they appear very relaxed. If any emotion shows its only in the last few minutes when they are digging to a deeper space than before and battling to keep the mental control of their form.

The point is that if you want to change the world you’re going to have to work hard, it will be incredibly difficult. It will take time to build up the skills and to work as a cohesive team to get things done. But you have to do it if you want to succeed. You have to learn to be able to relax at speed, to be able to raise your race-pace so that when others around you are gasping for breath and about to drop out, that you can put in a spurt and ease away.

I don’t know if there is a finish line in business, but looking back on the last few years I can see how we now sprint for two weeks only to sprint again. It’s not so hard anymore. I can see how easy it’s gotten for us only when someone new joins our team and takes a while to slot into the pace. I hope you’re seeing this too in your own business: don’t be discouraged because it’s hard. In a way it has to be hard. Your challenge is to find ways to make it easier: sometimes systems and routines can help; sometimes removing obstacles will help. Other times you’re going to have to see whether you can put your hands deeper into the fire, recover over night and do it again tomorrow.

You probably can. If you can’t, you’ll probably fail. Get out there and work on your race pace. Surprise yourself. Change the world. Do it again tomorrow. You probably can.