Business success rarely happens without planning. We recommend to our professional service clients seeking to maximize the value of their firms that they create at least a five year plan that includes key metrics to define how they will measure success. Here are some metrics that we believe are important to track:
- Net income, measured on the accrual basis of accounting and prior to interest, income taxes, discretionary bonuses, and discretionary contributions to retirement plans
- Revenue generated by direct labor dollar, by service (if applicable)
- Utilization (in dollars) direct labor divided by total salaries
- Percentage of proposals won, in dollars and in number of proposals
- Number of new customers
- Number of lost customers
- Team turnover percentage (employees who left divided by full time equivalents)
- Number of new services offered
- Revenue by service offering, especially niche services where pricing is less competitive than commodity-type services
We often get the question from our clients, “How much is my firm worth?” Unfortunately, there is not a definitive answer because it depends on a number of factors. For example, if you are selling your firm to an external buyer that has substantial capacity to integrate a new business, your business will be more valuable to that buyer than another buyer who is already at capacity and cannot reduce overhead costs as much. Or if you are anticipating a sale to an existing employee, these transactions do not typically demand as high a price as an external buyer will pay.
The “real value” of a firm is not determined until a buyer and a seller agree upon a price. Even then, there are nuances – how much will be paid at closing, will sellers be paid for a consulting and/or a non-compete agreement, is the price guaranteed, do certain benchmarks need to be met before the sales price is paid, do significant customers have to be retained for a certain period of time, etc.
Even though you can’t put a specific price tag on your business today, you should still be doing everything you can to maximize profitable growth, which will ultimately enhance your firm’s value. Key drivers to enhance the value of your firm are:
- Tangible book value
- Annual, sustainable cash flow
- A strong management team
- A history of increasing profits
Successful firms retain earnings from year to year and have a plan to enhance their internal growth rates via acquisition. They also begin actively seeking acquisition targets to meet their strategic goals once their company’s leverage reaches a predetermined amount. They do not wait for firms to approach them; rather, they approach other firms to determine whether they have an interest in selling.
To demonstrate the value of an acquisition, let’s assume that company A generates excess cash flows of $200,000 per year and the acquirer has agreed to pay $1,000,000 for the company. Assuming that the transaction is 80 percent financed with a five year 5 percent note, the acquirer should generate $180,000 of average annual cash flow ($200,000 less the average annual cost of the interest on the note), pre-debt service and the debt could be paid off by the seller’s cash flow within 5 years (i.e. the $200,000 investment is worth $1,000,000 after 5 years given no synergies from the acquisition).
This example would provide the acquirer’s shareholders a return of slightly less than 40 percent over a five year period. Add a 5 to 10 percent internal growth rate to the acquiree’s business, and you can see how significant enterprise value can be created.
There are numerous things that can derail your efforts to maximize enterprise value. Here are a few pitfalls we have observed, and that you should work to avoid:
- Owners who want all the cash at year-end, leaving the firm with no money to invest in the business. This is the problem we see the most, especially in firms with multiple owners that have not realized the benefits of retaining earnings. If there is not sufficient equity in the company, the firm will usually end up selling at, or slightly over, tangible book value when the market for their services shrinks.
- Firms that aren’t growing internally are challenged to keep their best people, since there is limited opportunity without growth.
- Overpaying or not doing enough due diligence on target companies.
- Not having a strategic plan so shareholders aren’t being held accountable to meet agreed-upon goals.
- As the firm grows, not continually enhancing the skill sets of owners and employees, or letting additional administrative tasks get in the way of serving clients.
- Being unprepared for retiring owners and needing capital to buy them out.
In summary, internal profitable growth is critically important to growing the enterprise value of your firm. Employees will recognize the opportunities they have to grow, banks and/or other lenders will be less reliant on collateral, and shareholders should be excited to continue the growth and their value within the company. Combining that internal growth with an acquisition strategy can create a model where stockholders realize returns on their investments in excess of 20 percent per year and attracting new shareholders suddenly becomes much easier.
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.