What Affects a Company’s Value?

January 1st, 2005

On a daily basis, we discuss issues related to value. "What’s my company worth?" and "I’m not selling for less than $___ million" (fill in the blank!) are things we commonly hear. For over 15 years, our firm has assisted buyers and sellers by performing business valuations. With hundreds of transactions completed, we have a clear understanding of the items that affect value in today’s marketplace.

It’s no wonder that owners want to know the value of their business and it’s also easy to understand why they typically do not know the value. The reason, of course, is that if they have a well-run business, they are probably spending their time keeping it that way and not worrying about its perceived value! Situations arise, however, when it’s necessary to determine the value of an enterprise. These can include thoughts of selling, divorce settlements, estate planning, partnership disputes, and more.

Following are the major items that affect value. Most important among the categories are financial performance, management and clients.

Financial Performance
Without question, the single most important factor that influences value is the financial performance of the company.

  • Earnings — 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 – Are revenues and adjusted EBITDA growing or declining over the past few years? Clearly, businesses with consistent and profitable growth are valued more aggressively than those with flat or declining revenue and/or profits.
  • Anticipated 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. While buyers will rarely pay all cash for these, they may pay the seller based upon future performance, thus improving the overall purchase price. (See my previous article in the Fall ’01 Kaulkin E-Bulletin for more information).

While financial performance is a major factor influencing valuation, this alone does not determine value. Other elements include:

How well established is the company?
Companies with a proven track record of stability provide buyers a level of comfort that can just isn’t there with younger, start-up companies.

Client Base

  • National vs. Regional – Are the clients blue chip, household names or are they local companies? Both could be attractive depending on the buyer. 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.
  • Industry specifics – Some client sectors are known for having lower and higher profit margins. Lower margins are often the result of increased competition in those sectors. In the collection industry, for example, credit card companies have notoriously "squeezed" rates downward that they pay their agency vendors. Such clients may be less attractive to some buyers who seek higher margins from an acquisition.
  • Specialists – Niche businesses can be attractive to buyers seeking to expand significantly in one particular area. Brand recognition and strong client relationships are two reasons that niche players are often attractive to buyers.
  • Client diversification – Red flags are raised when a company generates the bulk of its revenue from only a handful of clients. This is the old 80/20 Rule. The issue is risk, but interested buyers may structure deals to accommodate this. For most buyers, a well-diversified client base is preferred, because it eliminates significant risk elements.
  • Relationships – Long-term client relationships are ideal. They are proof that your clients like what you’ve done for them.

Certain services such as Outsourcing are growing in popularity and are considered "leading edge", while others are considered old-line (traditional). In the collection industry, for example, Outsourcing could include first party A/R management services as well as other services performed in the name of the client. Both new and traditional services could have value to the right buyer. 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 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 price will often be reduced by the expected amount of capital expenditures needed. This may, however, contribute to their interest level in the first place. In other words, if the company can be bought at a lower price because capital expenditures are necessary, buyers may see this as a good opportunity to acquire an otherwise attractive company. Another factor related to automation is whether clients are satisfied with the reporting capability, flexibility and response times of the company. All of these things lead to happy clients and happy clients lead to future revenue and stability.

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. Will the shareholders stay? What does the management team look like beyond the current owners? This can affect a buyer’s confidence level regarding the stability of the company, its client relationships, and its internal organization.

Legal and Accounting Affairs
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. Depending on the issue, it may not negatively affect value. In addition, certain types of lawsuits may be acceptable in some industries as "the cost of doing business". These should also be fully disclosed and depending on their nature, may or may not affect value.

What impression does your office give when people arrive at the front door, and after they walk through it? Are your managers and employees working hard and chipper or do they appear to have a chip on their shoulder? I’m not saying that a business needs to resemble a 5 star hotel with fine china and turn-down service, but in order to "show" well, it should convey a clean, organized environment with people who like what they do and are good at it.

It’s nearly impossible to cover all of the aspects that play a part in valuing a service business, but this discussion provides a basis for understanding the valuation items that matter to most of the buyers most of the time.

The Bottom Line
Businesses that excel across the majority of these areas receive top dollar when they sell. To truly understand the value of your business, hire an advisor that fully comprehends the marketplace in which you operate. True – your general accountant could probably get the job done for you, but if you’re going to pay for a professional service and you plan to base life-changing decisions upon it, you should get the most informed analysis available. Call an advisor that understands valuations within the context of the current pricing climate for your industry.

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