A Business Valuation is Not Just In the Numbers: Part One

A Business Valuation is Not Just In the Numbers

As a professional business appraiser, we are called to provide our best estimate of fair value.  On its face, it would seem relatively straightforward to assume that most of it has to do with the financial well-being of the company, which it does.  However, it is also very easy to overlook some of the more salient issues in the ongoing operations of a business which subtract meaningful dollars from its value.  In our experience, the issues most prevalent impacting potential valuations can be found in the following areas: financial operations, sales function, operations, leadership and culture, as well as owner psychology.  This article will outline a few of the key issues within these areas.

Financial

First and foremost, however, is the quality of the financials.  It is critical for a business to have strong financial and internal controls.  I have seen too many businesses fall flat on their face because they were still being operated much like they were when they first started out.

Operational infrastructure must evolve with the growth of the business, and the evolution of the financial function is one of, if not the most, critical components of a successful business.  Not having a strong bookkeeping or accounting function is perhaps the most important reason why valuations fall short of expectations, and why sellers often feel unsatisfied after the transition or sale.   In addition, poor financial management will often show itself in the financial statements and footnotes, which can reflect improper capitalization and/or cash flow management.  Each of these on their face would receive due scrutiny from a qualified appraiser in their analysis.

A good bookkeeper or CPA can help you set up a clear, concise chart of accounts and establish strong internal controls for the handling, measurement and access to funds.  Easy to follow, consistently applied procedures following generally accepted accounting principles is essential for an appraiser to gain an accurate assessment of the financial well-being of a business.  A business lacking in this critical area could face meaningful haircuts to value in an appraisal.

Budgeting and financial forecasting are two other key pieces of the financial function which are commonly overlooked by business owners.  Surprising to some, but most small business owners do not establish thoughtful and useful budgets.  These are the roadmaps used by effective managers in carrying out the annual action plan which typically forms the basis of a strategic plan, which most business owners generally do not take the time to do.

Multi-year forecasts are indeed useful for qualified appraisers who can incorporate these forecasts into their assessment, even if the weights assigned to these projections are less than the ones assigned to the historical data they can see.  Suffice it to say, a business appraiser will be able to paint a much more complete and holistic picture with this depth of information, which can also add meaningful value to a company.  In other words, the more complete and insightful information available to an appraiser, the more value can likely be recognized.

Sales

Sales is the lifeblood of a business – the mother’s milk so to speak.  It is certainly obvious, but you can’t have profits and value if you don’t have the throughput at the top of the financial statement.  Of course, a business owner is focused on generating sales, but a good appraiser will want to more deeply understand the source and consistency of that revenue.  An appraiser will also be concerned with whether the business has established leadership for the sales function, and whether that leadership has created and articulated a strategy surrounding revenue.  Far too often, we see businesses that start as order takers from a few key clients, but never evolve their marketing, advertising and client relationship management functions in tandem with overall growth.

Many businesses are adversely impacted by high customer or client concentration.  It is easy to assume these great relationships will persist into the future, but I’ve seen far too often where the law of the unknown takes over and the environment changes overnight.  Often, the landscape can change due to the shift in the business or ownership of the client, a falling out over service or capabilities, or even as simple as a dispute over price.  Large clients usually know when they have some leverage over the seller, and will try to use that to their advantage, especially when substitutes are available.  It is admittedly hard to know when and if a substantial change in customer mix may occur, but it is a meaningful risk that any good appraiser will take into account when applying the approaches to value.

Operations

The income approach to value depends in substantial measure on the ability of a business to generate consistent profitability, especially for its industry group.  Profitability comes from operating leverage; in other words, the ability to grow expenses at a rate less than sales.  Underperforming businesses relative to their industry code cohort will usually get valuation markdowns from qualified appraisers doing their homework.

An appraiser will also look at the management of the operation itself.  This includes not only the efficiency of the operations, but also the management of human capital.  Often, we see business lacking in some of the most basic human resources functions, including compliance and required training.  Sometimes, it is as simple as not even having a formal HR function at al.  Businesses really are as strong as their weakest link when it comes to human resources, meaning that a shortfall in this area could lead to considerable financial impact and embarrassment for the business, as well as a potential valuation discount.

From an operational perspective, an appraiser will be interested in both the data and so-called soft items.  These include an analysis of financial ratios, operating margins, as well as trends in in the data.  In addition, an appraisal should consider whether a company maintains proper oversight and management over facilities and equipment, purchasing, vendor management, suppliers, and even such things as intellectual property.  We are surprised by the number of small businesses which fail to effectively plan for such things as equipment utilization, repair and replacement, not to mention effectively negotiate and maintain contracts with business partners and vendors.

Jeffrey Elder, MBA is a Merger and Acquisition Advisor, IBBA Certified M&A advisor, and Texas Certified Business Broker for Austin, Texas based International Business Exchange (IBEX)

Eric Boyce, CFA is CEO and co-founder of BKA Wealth Consulting, Inc. and BKA Business Consulting, LLC.  He is a Chartered Financial Analyst (CFA) and he is a member of the National Association of Certified Valuators and Analysts (NACVA).