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What Drives Enterprise Value?

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felixtschopp_inisghts_visual_01Most owners think that the value of their business depends on financial ratios such as turnover and profit. But in fact, there are 8 key drivers for increasing the value of your business. So, how can you maximise the selling price of your business?

If you are ever considering selling your business, you will want to know what it is worth. Most people go to a broker in such a situation. He or she will ask you what industry you're in and then stick his or her finger in the wind: “So in this industry you're worth two and a half to three times your net profit.” Such industry rules of thumb have existed for a long time, and they do have some relevance. But they are a piece of the puzzle rather than the whole picture.

Let's take the example of a successful telephone support company that had nothing particularly flashy about it. Such service companies tend to trade at 1.5 to 1.8 times their net profit. This said telephone service provider made about 11 million in turnover with an estimated 10 per cent net profit. So their profit was around one million. So the enterprise value should have been somewhere around two million dollars.

In fact, however, the sale of a majority share took place at a selling price of a fabulous 39 million! That's a lot of money for answering phone calls. What is the difference?

This is where these eight booster criteria come into play, three of which in particular made the telephone service provider so attractive to an acquirer. These 8 drivers can also make the difference in your business.

1. Financial Performance

Your past income and profits and the professionalism of your bookkeeping.

This point is simple to understand: What is your turnover? What is your bottom-line profit? But it is not only about the amount of these figures, but also about the quality of the reporting. If you want to improve your bottom line, you should not only focus on turnover and profit, but also ensure through accounting that these figures look plausible. Because a buyer will always ask: How do you justify these figures? What third party has really audited these figures? Investing in an audit is an easy way to raise the financial valuation of your company.

2. Growth Potential

How likely is your business to grow in the future and at what pace?

The second factor in the saleability of your business is its growth potential. You can be as proud as an entrepreneur of what you have achieved, but a buyer is really only interested in the future: he buys your future profit streams. Suddenly, new questions arise. Can the company also operate in another market? Can it sell additional products and services to its existing customer base? Does the business model work in culturally different markets? The answers to these questions can skyrocket your growth potential.

3. Diversification of Customers

How dependent is your company on individual employees, customers, or suppliers?

Independence from any stakeholder is central to building a saleable business. First, you have to make sure that you are not dependent on a few key accounts. A good diversification of the customer base is essential. Secondly, the success of the company must not be tied to individual employees. A change must not shake the company. And thirdly, and this point is obviously not always as obvious as the others. One must also not be too dependent on a single supplier.

If a potential buyer sees that you are overly dependent on one of these groups (customers, employees, supplier), it simply becomes too risky for them. To improve your chances, go for diversification right from the start.

Using the example of our telephone service provider: this had around 6,000 customers who paid on average only a few hundred euros per month. The company could lose one or two customers every month without suffering a loss of revenue. For a buyer, this means: the revenue stream is bulletproof.

4. Cash is King

Is your business a money sucker or a money spigot?

When a buyer wants to buy your company, he not only has the purchase price in mind. He also has to factor in working capital financing. This is the money your business needs to operate on the day you hand over the keys to the buyer. The more cash your business consumes, the more problematic. The way to improve your valuation is to ensure that your business generates more cash than it consumes. If you are collecting debts, you should collect them faster. If you can delay your payables a little longer, do that and increase your liquidity. So net working capital should be steadily increasing, not just an indicator of profit, but of liquidity running concurrently with it.

5. Recurring Income

How do you increase the share and quality of automatic, recurring revenue?

When a buyer buys your business, they want to know what will happen when you, the owner, leave the business. The more recurring income you can generate, the higher the valuation. Recurring income can be divided into six levels:

  • Stage 1: the bread principle. You sell a consumer good that is always bought new.
  • Stage 2: the Nespresso principle. They sell a consumer good (coffee capsules) that is linked to a hardware (coffee machine) that they also sell.
  • Stage 3: the magazine principle. You sell a subscription with a start and end date.
  • Stage 4: the Bloomberg principle. You sell hardware (Bloomberg terminal) through which you offer services on a subscription basis.
  • Stage 5: the Netflix principle. You sell a subscription that renews itself.
  • Stage 6: the cloud principle. You sell services that are firmly integrated into your customers' business organisation.

Automatic renewal, or the contractual obligation of your customers to continue buying from you in the future, is the most solid form of recurring revenue. To improve your score on this attribute, you should try to climb the ranks of recurring revenue. So if you have subscription revenue today, think about whether you could convert it into auto-renewal subscriptions, or whether you could sign contracts for so-called evergreen subscriptions? Once you have reached your highest level, you should maximise the proportion of recurring income. The ideal would be one hundred percent. Very few businesses achieve this goal, but the higher the percentage of recurring revenue and the higher you climb the ladder, the more valuable your business becomes.

In the case of our telephone service provider: The company billed its customers for recurring contracts. This gave the buyer confidence in the future security of the company.

6. Your Differentiator

How well does your company differentiate itself from competitors in your industry?

When Warren Buffett talks about the deep and wide moat he wants around companies as an investor, he means that he prefers to invest in companies that have a differentiated marketing position. The more unique the offer, the greater the opportunity to control prices. The higher the profit margin and the more you can invest in sales and marketing—a nice little domino effect that allows you to be different. A marketing strategy must have two characteristics: Customer value and distinctiveness. So check all your messages in the market. Look at your website and ask yourself: are we different? And is that important to customers? These are the two factors that drive up your business value.

Acquirers don't buy what they can easily make themselves. And if your main competitive advantage is price, a competitor will quickly poach your price-sensitive customers.

In the case of our telephone service provider, the company invested heavily in technology that ensured that regardless of when a customer received a call, they were transferred to an available receptionist. At the same time, most of the competitors were mostly technically unsophisticated micro-businesses that often missed calls when there was a sudden rush of callers. Thanks to this unique routing technology, the company was able to handle high volumes of customers and route the calls efficiently. The buyer of the telephone service provider, a private equity firm, recognised this potential for other businesses it owned.

7. Customer Satisfaction

How likely is it that your customers will buy from you again and recommend you to others?

It is obvious that the satisfaction of your customers is important for a buyer because when a buyer buys a company, he buys his future. That is why you should measure customer satisfaction empirically and quantitatively at an early stage and continuously optimise it. Probably the most popular and respected method for this is the so-called Net Promoter Score. Essentially, this measures the probability that your customers will recommend you to others. The more data you have, the more meaningful the result. And the higher the value of your company.

8. Make Yourself Redundant

How would your business develop if you were unexpectedly unable to work for three months?

The issue of dependency discussed in point 3 above also applies, of course, in relation to the founder, owner and managing director. A potential buyer will want to know how the company works after you have left it. The more dependent the company is on you personally, the worse your selling position will be. Not good if all employees rush to the managing owner when they have a question. Problematic if customers only turn to him when they need something, or all suppliers only knock on his door. All too often, business owners are proud of this way of working and boast about the efficiency of the system. Efficient it may be, but if the business owner fails as a central hub, there is not much value left in the business. Make sure your business becomes less dependent on you. Document your processes. Empower your employees. Make sure you have all the things printed out in their heads so that they can read, understand and implement them when you are not there. Start small: Take a holiday and see how your business works in their absence. When you come back, find out where the glitches were and start plugging the holes. And then take another holiday, a slightly longer one. Find out what you need to reinforce before you yourself, in terms of optimising the value of the company, have become redundant.

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