A lot more than your business's financial statements determine its true worth.
- The top three nonfinancial factors that can drastically affect business values are management structures, diversity, and growth potential.
- If you’re the buyer, these factors can help you see the bigger picture outside the numbers and get an idea of what’s actually driving the business's success.
- If you’re the owner, these factors can give you a sense for which value drivers are important and what levers you can be pulling to maximize the value of your business for potential buyers.
While numbers can tell you a lot about how much a business is worth, it can't tell you everything. When considering buying or selling a business, there a number of vital factors, unrelated to finances, that must be considered.
Determining the value of a business starts with looking at several years of data to determine growth trends – monetary and otherwise. Has the company been improving, or have earnings been flat? How has the internal structure evolved? Maybe the owner has already checked out and the company has been slowly going downhill for several years. We like to call this the "glider effect," and, unfortunately, it happens a lot.
Gliders, without the benefit of an engine, may float for a while – but they always come back to the ground. Without the jet propulsion of drive and a healthy appetite for risk-taking, the same often happens to business owners.
It's a curious thing that sometimes happens as business owners get older: They tend to become more risk-averse. Rather than getting excited about borrowing millions of dollars to invest in their businesses, they become more fearful of taking on any debt or risk. They move from wanting to invest in technology to keep pace with the industry to thinking, "our processes work just fine.” Or maybe they stop replacing employees with poor performance, deciding that as long as work is getting done at a minimal level, they don't want to rock the boat.
While the financials and cash flow of the company are crucially important to the value of a company, non-financial factors can literally make a company unsellable. In fact, non-financial factors often make or break a sale.
A common issue with small-to-medium-sized businesses is the amount of involvement the owner has in the company.
For example, my company recently listed a successful trucking and logistics company. It was spinning off more than $500,000 a year in cash flow and attracted buyers from several states – but, ultimately, the company was unsellable. In the Value Builder System, we call this the hub and spoke. The owner was the hub, and the spokes were all his customers, employees and suppliers. They all came to him.
If you took the owner out of the picture, everything stopped. He was the company. With $500,000 in earnings, the owner had more than enough money to hire a manager or someone to delegate this work, but sadly he never did out of pride. Deep down, it seemed that he enjoyed feeling like the business depended on his involvement (which can be a common theme among business owners who, at some point, have transferred much of their personal identity to the business). After a year of working with him, and seeing his unwillingness to hire someone, we terminated our relationship. To this day, the company has not sold.
Clearly, it's important to maintain a focus on the non-financials that can make or break a company's sellability. Here are three non-financial factors to consider, whether you are the business owner or a potential buyer.
1. A strong management team
Take time to consider whether the business would come to a standstill without the owner's involvement. What percentage of involvement would be required from the owner for it to continue to generate its historic cash flow?
As I noted in my example above, the reason some companies don't sell is that they are entirely dependent on one person. If the owner is the entire company – the "hub" of the wheel – then the wheel is easily broken once he or she leaves. All the spokes (the other stakeholders, partners, employees, etc.) crumble without the hub holding them together.
Instead, if an owner puts a strong management team in place, it directly impacts the health of the business. It becomes easier to train the new owner on the inner workings of the business from a day-to-day standpoint and ensures the longevity of the business if key employees stay on with the firm.
It's vital that owners, in particular, take time to evaluate this early. However, one-third of business owners have not considered management succession because they've been so focused on the day-to-day aspects of their businesses. Only 25% of them are confident that their management teams would be successful without the owner's involvement.
As an owner, start by evaluating your employees and determining how you can cover vital responsibilities in your absence. Some selections might be obvious: a one-level promotion for all key employees, for example. But there also might be wider gaps that you’ll have to get creative to fill. In some cases, you might have to bring in outsiders: board members, accountants, or personal contacts who have the appropriate experience. Without these considerations, you're only selling a job, not a company.
2. Diversified human capital risk
When a company is dependent on any one customer, employee, or supplier, it can be equally detrimental. For example, if a single client provides more than half of an owner's income, the owner becomes more of a contractor than a business owner. Plus, it poses a huge risk if a client stops requiring the business's services for any reason.
One common issue is when a company is overly dependent on a few key employees. My company was tasked with selling a drilling business in which two key employees were not tied down with any type of "golden handcuffs." This presented an issue when trying to sell the business, as the buyer had no guarantee whether the employees would stay on with the company post-sale. This is a common problem — in one study, 33% of acquired workers left within the first year of a company's sale.
As an owner, reduce your dependency on any one employee, customer, or supplier. If you have key employees, research ways to put those "golden handcuffs" on so they stay. If you have a customer that is more than 10% of your business, it's time to diversify. Or if you are tied to a supplier, consider whether you can you diversify that dependency among a group of suppliers.
3. Growth potential for customers, markets and products
While financial statements can be indicative of a company's growth potential, there are a number of non-financial elements that can paint a clear picture of its future (or lack thereof).
Ask, "What is the growth potential of the company?" If someone took over the company, could he or she expand it? Would it be possible to duplicate the business model in another city or state?
Potential investors or buyers want to be able to see a clear growth strategy in the business plan, including expansion in customer base, markets and potentially even products. Then, they want to see how this will impact sales and the bottom line.
It's hard to weigh financial and non-financial issues. If a company is not making any money, it definitely isn't going to have much value. But, too often, owners of financially successful companies don't realize they're actually unsellable because of a non-financial issue.
By keeping these factors in mind, owners can steer clear of the "glider path" trap, and buyers can watch out for it as a red flag. If the company isn't actively growing, it can only glide for so long before it falls back to the ground.