We are taking a close look at the anatomical parts of a valuation, discussed in our recent webinar The Anatomy of a Valuation: What Your Company is Worth and Why, where we were joined by Bonnie Wilhelm, CFO, and Brandon Farber, Director of Finance, at Perseus Group.
Whether you are just curious what your company is worth, or you are considering selling, there is a lot that goes into understanding how your company is valued. Last month, we explored key terms to understand in order to figure out your company’s value. Here, we dive deep into the mechanical pieces of valuation models and eight key factors that can affect your company’s worth—good and bad.
Key Factors to Consider
There are eight key factors we examine to help you determine your company’s worth, along with value and risk factors that can affect a valuation.
This is the most important factor we’ll discuss, because you have control over it. Revenue is the first thing we assess when we look at a company, and we immediately ask ourselves if there are opportunities for revenue growth.
The first thing a buyer will assess is their ability to maintain or increase revenue. They’ll look at what’s been done in the past and what’s contractually permissible.
“If I were in a position to say, Okay, I want to sell my business three years from now, what should I do to really maximize its value?” posits Bonnie. “I would focus on revenue.”
Revenue is one of the factors entirely within a seller’s control. When we first think about revenue. What are the opportunities for revenue growth? Buyers will look at contracts
When evaluating the potential for revenue growth, consider whether your business has:
- Pricing power: how much pricing power does the business have? Has it increased or decreased prices in the past and can it do so going forward?
- A consistent historical precedent of new client growth: Are sales and marketing consistently supporting a strong pipeline?
- Customer churn: A consistent historical precedent of low customer churn will be favored. Where churn rates are higher, a seller will want to vet the quality of the sales and marketing engine to mitigate risk.
- Projected overall vertical market growth: is this segment growing? How much opportunity for growth exists in the market that translates to revenue growth?
- Long-term contracts: the longer the contract, the more reliable recurring revenue you can tie to your business.
- Customer concentration: customers that represent a high percentage of your revenue, present risk. A buyer will need to talk to them, see NPSs, and ensure the risk is fully understood and manageable.
“We have seen periods of significant growth, as well contraction, in our homebuilder and real estate markets. We typically try to balance what we believe is reasonable and bridge that gap with an earnout,” Bonnie adds.
Take the difference between your revenues and your expenses, and you have your margins. When your company grows, so does its ability to scale. When looking at margins and a company’s ability to scale, an investor or buyer will consider:
- Staff: is a company able to grow revenues without increasing headcount? Once a minimum labor pool is established, a company can focus on improving efficiencies. Two teams of the same size can come with different costs and bring in vastly different amounts of revenue, affecting margins.
- Vendor costs: typically as a company grows, they’re able to secure lower costs through volume discounts. SaaS companies typically incur high hosting expenses to start up. Is revenue increasing at a faster rate than hosting expenses?
- Interest rates: the larger a company is, the ability to lower interest rates become available.
A few percentage point change in margins can materially affect a valuation, so it’s critically important to understand revenues and expenses, how they scale as a company grows, and how they can impact your bottom line.
Sometimes a buyer will purchase a business that will become a product line of a larger company, where margins can be improved through centralized resources, or synergies.
As we’ve discussed, synergy refers to the value and performance of two companies yielding better results combined than the sum of their individual parts.
Synergies are very specific to each buyer, depending on existing businesses they own within a vertical or resources available.
Sometimes a business will be referred to as subscale, meaning they have negative operating leverage and high costs. Constellation uniquely leverages its network of resources to provide companies scale and operational support that create efficiencies, improve margins, and offer lower costs structures across both our organization and customers—all value drivers that result from strong synergies.
While Constellation companies typically operate independently, we have a large administrative staff that can take over finance, benefits, and legal. When administrative costs are reduced, margins go up, and the business is almost immediately more profitable than before.
Some considerations as you think through potential synergies:
- Does the buyer own pre-existing vendor contracts that result in lower vendor costs?
- Are there opportunities to cross-sell with other businesses a buy owns?
- Does the buyer own other businesses within your market?
There are various levels of operating leverage that may be obtained post-acquisition that can flow into the valuation.
When thinking about synergies, consider the benefits that come from combining businesses and resources.
Unlike revenue growth and margins, tax rates are mostly out of your control. For instance, when we buy a company based in the US, we are subject to state income tax rates. This is especially difficult in California, where state tax rates are particularly high. High tax rates can impact a valuation.
There are situations that are advantageous to both parties to minimize the total amount of taxes each pays, including ongoing corporate income tax and taxes paid during the transaction.
It’s never just the buyer and the seller involved in the deal—it’s the buyer, the seller, and Uncle Sam. There are transactions where the buyer and seller are able to come up with structures that pay less in taxes, benefiting both parties. It doesn’t always have to be a zero-sum game.
Tax rates are often impacted by:
- Changes in tax regime policies
- Changes in transfer pricing methodology
- Geographic changes in legal entities
Debt isn’t always a bad thing and can actually be leveraged to your advantage. Many buyers use debt as part of their acquisition structure and even their long-term ownership structure.
Many business owners leverage debt via:
- Loans from the government
- Loans from the bank
- Loans from shareholders
- Lines of credit
If debt is leveraged debt to grow the business and get to higher revenue streams more quickly, the cost of that debt can be a big advantage, especially since debts are generally paid off as part of the proceeds when a business is sold. A lot of times, the cost of debt can be more valuable than the debt itself because the interest paid can be deducted.
On the flip side, if debt is accrued at a faster rate than a business can grow its revenue streams, it might not be able to sell the business to cover the debt owed. Debts will ultimately be deducted from the overall cash flows from a business so, if the debt owed is more than what a buyer is willing to pay, a company can find themselves in over their head.
One real-world example is PPP loans in the U.S.—during COVID the government offered a number of short-term loans that could potentially be forgiven. A buyer will want proof that these loans will be forgiven, but sometimes the structure of the post-close entity is different than the one the government issued a loan to. In these cases, we’ve seen buyers jump the gun and not be as prepared to close as they could have been.
In any situation, businesses that are selling need to have dependable cash flows to pay their debts in order for them to be successfully leveraged.
Net working capital
Net working capital is the difference between a company’s current assets and its current liabilities. A lot of confusion circulates around it but, in laymen’s terms, the sooner you get your customers to pay, the sooner you’ll have additional cash.
A company’s working capital can fluctuate over time, depending on operational costs and how customers are billed. An investor will annualize a business’s accounting to assess liabilities on the books, followed by a long reconciliation process that most sellers aren’t familiar with where liabilities, assets, and future cash flows for a typical 12-month period are considered.
Negative working capital is the result of current liabilities being greater than a business’ current assets.
One example of an event that can complicate working capital is annual billings. If a customer pays for a year in advance and a business is acquired, the new owner is now liable to service that contract without those cash flows from that customer for the next 11 months.
Common events that could result in negative net working capital include:
- Low cash position
- Annual billings
- Not paying vendors on time
- Customers paying on time
Positive working capital comes from a business having more current assets than liabilities. Positive working capital is a sign of a company’s financial strength.
Events that result in positive net working capital can include:
- High cash position
- Monthly billings
- Paying vendors on time
- Customers paying late
Cost of capital
The cost of capital comes down to the rate of return a company needs on an acquisition. In order to determine your company’s cost of capital, you need to figure out your potential buyer’s hurdle rate, or the minimum rate of return required on an investment and if your business fits that risk profile.
“What is the buyer’s hurdle rate?” asks Bonnie. “What the buyer can pay for the business. This is something Constellation tries not to talk about publicly; this is our biggest competitive advantage or disadvantage, depending on how you look at it. The consideration as a seller is, what is the buying entity really looking for in terms of their return?”
A deferred tax asset is typically created when a company has historically losses, it is entitled to deduct that loss against taxable income in future periods. Deferred tax assets can be used to make your company more marketable to potential buyers who generate positive net income.
On the other hand, a deferred tax liability represents an obligation to pay taxes in the future which can arise due to differences in net income from an accounting and tax perspective.
Feel free to reach out directly to share your thoughts and questions.
President and Managing Partner
Constellation Real Estate Group