The Four Metrics of Valuation

Whether it's during an application for a loan, a partnership venture, seeking investment, or creating an affiliation or alliance, the valuation question is the same: what is your business worth?

The next question then on most business owners' minds of small businesses is how do I go and figure out a value? Frequently, that discussion gets sidetracked into confusion of "How do I start?" or "There's no way that I'm going to sell my hard for pennies on the dollar," and so on. A true valuation needs to be based on objective factors that can't be disputed later as made up innuendo or anecdotes. Clear metrics and benchmarks are needed so that when the true discussion of change occurs, it's not distracted or bogged down with questions about number validity.

So to clarify what goes into valuation, it's best to understand the factors that create a value figure. These are going to include financial activity and performance, management and supervision, and the all-critical client portfolio.

1. Fiscal Metrics

Without question, the single most important factor that influences value is the financial performance of the company. Since service businesses are cash-flow oriented (unlike manufacturers which have considerable hard assets), values are often based upon adjusted EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) generated over the past twelve months. Adjusted EBITDA is the profit number that the buyer can reasonably expect to generate if it owned the company. It takes into account the various "perks" that many owners enjoy and is often a point of considerable negotiation in transactions.

Trends and patterns are reflected in revenues and adjusted EBITDA, so a review will look at whether they are growing or declining over the past few years. Businesses with consistent and profitable growth are valued more aggressively.

In terms of future growth, if new clients recently came aboard or perhaps a proven salesperson has just been hired, the company's financial performance could improve and therefore these kinds of scenarios could certainly affect value.

The length of operational history is important as well. Companies with a proven track record of stability provide fiscal review a level of comfort that can just isn't there with younger, start-up companies.

2. Client Metrics

If the buyer seeks to be a regional player, the local clients may be a plus, whereas if the buyer seeks to be national in scope, it would likely value "name" clients more. Client evaluation is then broken down into industry types to base their worth on expected profit margins. Some clients may be less attractive to some buyers who seek higher margins from an acquisition. Another client slice is whether they represent a niche business expansion. Brand recognition and strong client relationships are two reasons that niche players are often attractive to buyers. How well the client base is spread can be an indicator of a small business' economic resilience. Red flags are raised when a company generates the bulk of its revenue from only a handful of clients. Finally, long-term client relationships are ideal. They show customer retention and revenue flow. And they prove that your clients like what you've done for them.

3. Management Strength

A big key for most buyers is whether or not a quality management team exists and whether it will remain in place after the deal. This can affect a buyer's confidence level regarding the stability of the company, its client relationships, and its internal organization. And management is more than just the supervisors involved. It also includes how operations are managed and how they relate to profit production.

Many also feel that if the company offers multiple services, it can entrench itself with its clients and strengthen those relationships. Providing an array of services is useful in attracting new clients and is understandably sought-after by potential buyers if the services generate significant profits.

Highly efficient automation systems improve operating margins and the reverse is also true. If buyers view a company's systems as outdated and in need of a major overhaul, the business price will often be reduced by the expected amount of capital expenditures needed.

Presentation reflects management. If your office is a hole in the wall, why would anyone think it's any less risky than a fly-by-night operation? Your office and where you meet clients' needs to reflect the seriousness of your business and credibility if you want investors to see things the same way.

4. Legal Issues

The biggest sore thumb for any business value expectation is if there is an obvious pending legal dispute hanging over the business. However, other legal issues not yet "exposed' can be issues as well. Are there any accounting "irregularities"? If so, they could be early indicators of client loss and they need to be addressed. If the financial statements are not squeaky clean, they should be rectified prior to selling, or at the very least, fully disclosed to prospective buyers early in the selling process.

Conclusion

Clearly, businesses that do well on all the above metrics will get a higher price and value and those with issues. But for those with lower numbers, many of the issues are reversible if a business owner can learn to identify what the problems are from a valuation perspective. Hiring a professional valuation advisor who is well-experienced in the industry that you work is a significant help. Is it necessary? No, a good CPA accountant could get the basics pulled together. However, using a professional industry-specific advisor who understand valuation beyond just financial statements can be the difference between a mediocre value and very good, best-information valuation that has a high value.

Neil Lemons is an independent writer who enjoys writing articles to be used as business valuation resources. He has years of knowledge, and has written many articles about business valuation, with a particular focus in the business litigation services arena.

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