5 Ways to Increase Business Valuation | The Exit Strategy Formula
In this post, we will explore some proven methods for increasing your company's valuation by recognizing how the business valuation formula works.
As a business owner, you are always looking for ways to grow and increase the value of your company. Whether you're a startup or a well-established business, these strategies can help you reach your goals and take your company to the next level. So, let's dive in and see how you can increase your company's valuation today!
How can you increase your company's valuation? There are 2 main value levers a business owner can pull to increase the fair market value of a business:
cash flow; and
the risk of that cash flow.
Before we dive into how you can increase the value of your business, let's quickly get on the same page about what business valuation is and the various business valuation methods.
What is a business valuation?
What Is Business Valuation Exactly? Here's a Beginner's Guide. But as a quick recap:
Business valuation is the process of determining the worth of a business. The worth of a business can also be referred to as the market value, the present value, the net present value or the enterprise value.
During the valuation process, the cash flows, assets and liabilities of a business are examined.
Both the historical and future cash flows of a business are relevant. We try to use the historical results as a point of comparison when assessing future growth projections.
We also analyze a company's assets, both the tangible assets on the balance sheet (cash, accounts receivable, inventory and equipment) and the intangible assets (intellectual property and goodwill).
The purpose of a business valuation is to determine the true value of a business based on a variety of factors. Many business owners turn to certified public accountants to estimate their business value objectively. A business appraisal valuation is contained in a report when it's prepared by an expert; while an informal valuation without a report is also common, they often lack a list of the key assumptions making it harder to understand how they arrived at the conclusion.
How is valuation is calculated?
All business valuation methods attempt to estimate the cash an owner expects to receive as a result of holding the investment (in today’s dollars).
If the value of a business is derived from the business assets, an asset-based valuation will set aside the company's profits and rely on the book value of the tangible assets.
If the company's earnings are key to the value of the business, the sale value will be best estimated using an income approach. Income approaches include the discounted cash flow method, where the economic value of the future sales revenue (and, therefore, future earnings) are estimated.
If there are easily observable transactions involving similar businesses, a market approach may be the best valuation method.
The business valuation formula
Asset-based methods formula
When the future cash flow from an investment is best estimated using an asset-based approach, the business valuation formula is simply the value of the company's assets and then subtracts liabilities.
Income approach formula
If the owner of the business is most interested in the income-generating ability of the business, an income approach is used to estimate the fair market value.
A discounted cash flow analysis is used to estimate the present value of future earnings when the future profits are expected to vary year-to-year. The formula here involves future cash flows and a discount rate.
A multiple of earnings analysis is used to estimate the present value of the future earnings when the future profits are expected to be similar year-to-year. The formula here involves an estimate of maintainable cash flow and a multiple.
Market approach formula
A market-based approach estimates the current market value in relation to transactions involving similar businesses. Here, implied multiples are extracted from other transactions. For example, if a consulting business sold for $1 million and generated an annual cash flow of $400,000 per year, the business sold for 2.5 times cash flow (aka a multiple of 2.5 times). Therefore, this formula involves estimated cash flows and a multiple.
Key Elements of a Valuation Formula
To summarize the above, all business valuations involve these value levers:
The value of the company's assets
A company's liabilities
Future cash flow
Multiples (or discount rates)
Increasing Business Value
As noted at the beginning of this article, there are 2 main value levers a business owner can pull to increase the fair market value of a business: cash flow and the risk of that cash flow.
Most businesses are valued as a going concern (using an income or market-based approach) rather than on a liquidation value basis. Hence, the value of a company's balance sheet (tangible assets and liabilities) is not our primary focus when trying to increase company valuation.
With that in mind, let's dive into 5 legit ways an entrepreneur can increase the value of their business.
1: You need 3 years of solid EBITDA to sell at the highest price
To get the highest price when you sell your business, you need to have 3 years of solid EBITDA (earnings before interest, taxes, depreciation and amortization).
Why this works: Having 3 solid years of recent historical cash flows shores up the risk of profits. Imagine if you didn’t have 3 solid years, you’ll be trying to convince potential buyers that your future projections are accurate. It will be an uphill battle, and more often than not, a buyer isn’t interested in paying for profits you haven’t been able to generate yourself. They will have to generate those higher profits themselves and aren’t wanting to pay you for their future efforts.
2: get out of the way
To get the highest business valuation, ensure the business's future is not dependent on you as the owner-operator. If tasks and responsibilities can be delegated and less concentrated at the top, then any change at the top doesn’t have such a detrimental impact on profits.
To maximize the selling price, ensure there is depth in the management team who will remain with the business. Buyers will pay less for a business if they are going to lose key management, whether those key people are departing shareholders or all the senior team members are of retirement age.
Why this works: A small business is more valuable when it is not dependent on certain people to run it. If I’m an investor, I want to be able to generate at least the same annual earnings whether or not the founder or key management stays working in the business.
3: sell at the right time
The best time to sell a business is when there is a track record of growth, but there is more growth to be had. You want to be able to show the last three years were in a growth mode with improving financial results.
Why this works: You want to sell your business when a prospective buyer thinks it is likely that the business will be able to generate either the same cash flow as the year before or we'll be able to generate the cash flow estimated in the projections. Put another way, you want the buyer to assign little risk to the company's ability to generate cash flow.
4: get more bidders at the table
If owners of small businesses receive unsolicited offers and want to sell, they should get more bidders to the negotiating table. If you have more than one buyer at the table, you are more likely to get fair value for your business.
Why this works: Because of the economics of demand versus supply, you generally need a sufficient number of market participants to achieve a fair price. If there is only one buyer and one seller, the price negotiated in a transaction might be higher or lower than the fair market value, given differing negotiating abilities, availability of information, and motivation to buy/sell. If there's only one interested buyer, you can't leverage another bidder's price. Of course there are exceptions to the rule, but more often than not, higher sale prices are achieved when there are more interested buyers. If you are in a position of just having one buyer, try to get more to the table to increase your business valuation.
5: do a preliminary business valuation now
To increase the value of your business, go through the exercise of valuing your business yourself now. Once you have a starting point, you can work to increase the value.
Why this works: Business owners often wait until too late in the process to arrive at their own value estimate. If you wait until right before you go to sell, you don't have time to increase the business valuation. The worst thing you can do is find a buyer, negotiate a preliminary price, and then realize the price is lower than what you want when it comes time to paper the deal (aka draft a purchase and sale agreement). Be sure to know what you think the business is worth before you start the process of selling your business. Say after the exercise of valuing the business yourself, you think the value is too low, you'll still have time to tweak the business to get a higher valuation.
Wrap Up
In conclusion, increasing your company's valuation is a vital goal for any entrepreneur. One important factor to consider is having at least three years of solid EBITDA, which demonstrates the financial health of your business and makes it more attractive to potential buyers. Another key aspect is ensuring the business's future is not dependent on you as the owner-operator, as this can make it more difficult to sell.
The best time to sell a business is when there is a track record of growth, as this shows potential buyers that the company has a bright future.
Additionally, getting more bidders at the table when you go to sell can help drive up the value of your business.
As a final step, it is recommended to go through the exercise of valuing your business yourself now. This will help you understand the strengths and weaknesses of your company and allow you to make any necessary changes to increase its value. By following these strategies, you can increase the value of your business, be well-prepared for a business valuation appraisal, and increase your chances of a successful exit in the long run.
Next Steps
For step-by-step help in valuing your business, I created The Valuation Formula, the one formula you need and the insider strategies to negotiate the best price for your business. You can learn about The Valuation Formula in my free Masterclass: How to Value a Business and Negotiate the Best Price…Without Complex Excel Models, a Degree in Finance or Access to an Investment Banker.
