“The price an investor is willing to pay for an asset relates to how risky he or she perceives the future stream of profits to be: the riskier the investment, the higher the return an investor will demand.” Excerpted from “The Math Behind Your Company Valuation“
When pursuing financing or the sale- whole or partial- of your business, please keep this excerpt in mind. You may think your business is an amazing investment. However, try to look at your company from an investor perspective in order to determine if this belief is based on concrete information or just on your love of the business.
Another excerpt: “But when buying one relatively risky business rather than a balanced portfolio, investors will expect a much higher return on their money. For illustrative purposes, imagine an investor is looking for a 50 percent return for buying your business because he or she deems your future stream of profits to be very risky (or the likelihood of you meeting the targets very uncertain).”
When individuals and companies buy companies, they typically pay for businesses based on their past performance. However, they are buying because they think they can command a fairly high return on the business either through cash flow (rare) or through the increase in price when they sell the business or take it public. And yes, the riskier the business, the higher the expected return.
“In the end, as a business owner, you have three levers to manipulate in order to increase the value of your business for a financial buyer: how much profit you expect to make in the future, the rate of growth of your profit each year, and the degree of risk associated with your future profit stream.” Excerpted from “The Math Behind Your Company Valuation“
If you want to position your company for sale at an optimal price for you as the selling business owner(s), whether it’s to a financial or strategic buyer, an individual or a larger company, or to an ESOP, you need to strengthen your financials. Buyers look at trends. Using the above, if you can increase your profit margin from 7% to 12% before you sell, you increase the cash flow now. Cash flow is what largely determines the sale price. (There are industry exceptions to this rule.) This also increases future profits, making the buyer more comfortable and warranting today’s higher price tag. If your revenues grew from $3 million to $5 million as your profit margins increased, you now have a much higher bottom line growth rate. If you then also expand your customer base and reduce your reliance on your top 5 customers from 60% of the revenue to 45%, you’ve reduced the risk of a significant adverse impact if you lose a customer, thus lowering the risk of the future profit stream.
Check back tomorrow when I provide some basic valuations to further illustrate the point.