The 10 soft factors that affect the valuation of a business
This post intends to give a quick view on why business valuation comes to different results on seemingly similar businesses. Making a financial valuation gives a gross indication, but a number of adjustments needs to be made. Those are the judgment calls. It has nothing to do if being a valuation of a running business, a corporate sale or for new funding.
The gross financial valuation is discounted or enhanced with soft factors
There are hard facts and soft facts in the broad concept of business valuation:
- The hard-fact is the mechanical financial valuation that comes to a preliminary value of the business. A preliminary number. There are different financial valuation methodologies depending on the the maturity stage of the business and the availability of financial figures. Start-ups have limited financial data available whereas a running business have historical and projected financial statements. The outcome regardless of methodology is the gross value of the business.
- The soft factors are the all-important judgment and assessment factors applied to the preliminary financial valuation. This is the qualitative and partly subjective part of the business valuation that makes up the final value assessment. Considerations includes the growth rate, management quality, scalability, etc. These factors either discount the preliminary financial valuation, or enhance it.
The list of 10 soft factor that affect the valuation outcome
Here is the list of the 10 soft factors that affect the valuation outcome of a business. Keep an eye on these intangible areas. Address those in business planning, with the leadership and in daily operations and you will create value:
- Sales traction: Businesses that has reached a steady momentum of new revenues are deemed valuable. The likelihood of continued success is higher than for businesses with single-customer dependencies or revenues that has just recently taken off. You can read more hear in a previous post.
- Sales stability: No one likes uncertainty. Stable and predictable revenues are more valuable than volatile revenues. You can read more hear in the similar previous post.
- Business model: When assessing the value of a business it is important to understand how the business model work. How is revenue generated, to what extent are those revenues recurring or one-offs? A business with recurring revenues is obviously more valued than a business where not only new revenues but also current revenue levels are dependent upon continues new customer acquisitions. Other business model assessments include the level of involvement of partners and subsuppliers. It can be cost or scale effective but it also means that parts of the value creation is done by someone else. I.e. a high revenue level may still lead to low gross or operating profit levels if partners or subsuppliers have large stakes in the business model.
- Scalability: Second to sales traction, sales stability and the business model comes scalability. I.e. how scalable is the business model? A well-designed online ERP-system is very scalable since the product and production is basically the same to every customer. On the other end of scalability is a traditional consultancy business. Revenues are limited to the number of hours each consultant can bill. Industrial companies seek scalability in scalable product platforms, in added services and in after-market businesses. To find leverage in the business model and to search for scalability is one of the most important soft quality factors when assessing the value of a business.
- Management quality: People makes the difference. There is a saying that good management can fix a poor business but poor management will ruin any business. A business with high dependency on a few key individuals is a higher risk and hence less valued than a well-organized business with defined processes, roles and responsibilities. Individuals can leave or become ill and it is the responsibility of any business owner to ensure that the business is as sustainable as possible. Succession planning including relevant nursing are part of a soft-factor valuation due diligence. How processes are defined, documented and followed in practice is another important area. Organize your business from your key processes or from your markets, not the other way around.
- Production set up: Depending on your business this can be a value creator or limiter. Operating lean with partners and sub-suppliers has many advantages including capital, competence, resources and scale. However, operating part of your own production has advantages as well. You gain product development synergies, you will be in a better control of your margin development and of continues improvement activities. In some instances, you also enhance your business value. In addition to the mentioned benefits you will enhance your value if your customers would put (intangible) value to your business if being “complete” and more relevant with in-house operation competence, experience and control. Having your own production capability would in many cases be beneficial to your brand, i.e. how your customers would view you as a relevant and trusted partner.
- Branding: Perception is everything, some people say. Some marketing is necessary regardless were you are on that belief. Your customers view of you and your business is your brand, and you can be proactive. Be it content marketing on your web page to establish your industry relevance, participating in visible industry projects, fairs or other events. Nursing your brand is of particular importance when to attract those new customer relationships, including those key decision makers you will not even meet. You can read more on that hear.
- Working capital: Managing working capital is extremely important, not least when in growth mode. Growing your working capital requirement will put a stretch to your financing facilities. An increased debt level means your equity value goes down (since equity value equals your discounted cash flow less debt, see more of that below).
- Investments: A well invested business has good makings of being long-term successful, hence value positive. However, over-investing leads to increased debt (or reduced cash) which is detrimental to equity value. Equally, an underinvested business may improve the short term financial position but will be value destructive at a closer due diligence. Lesson learned; maintenance investments are important and new investments shall be designated towards growth or quality. Avoid those nice-to-have investments.
- Net debt: The discounted cash flow valuation of your business, after soft-factor adjustments, covers the entire company. The money you as an owner will receive is that discounted cash flow value, less the debt level in the company. That is because a buyer takes not only the company but also any debt that the company has. That residual sum is called the equity value and that is the net you get paid if selling your business. Lesson learned; manage your business lean, in particular working capital, keep an eye on expenses and focus a lot on sales volume and margins and you will limit indebtedness to the extent possible. Hence, improving your equity value.
Each business is valued differently. You will maximize your equity value if managing your businesses prudently, with common sense and a focus on the entire business. Please read more on that hear. Maybe that last part is the most challenging one for most entrepreneurs. Most people have skills and interests in one or two specific areas, e.g. sales, products or operations, while building a business and targeting value creation involves a long list of needed skills and attentions. Building the right leadership and team is therefore the final advice on value creation and actually a key part when assessing management quality during business valuation.
Thank you for reading. Please feel free to like, comment, share, tweet, email, etc. Hopefully the Pareto principle, also known as the 80-20 rule, will apply. I.e. 80% agree and 20% will give a constructive challenge.