United Arab Emirates
1.Developing a Diverse Customer Base
Do you know one of the most important elements in a business acquisition is diversified customer base, a company with a customer base in which no single client accounts for more than 8-10% of total sales makes the business further more attractive and improves the valuation strength?
A well-diversified customer base protects your company from the loss of a major customer. For instance, if a company generates around 40% of sales from top 5 customers, the risk of loss of business in such cases is very high as one client default can result in catastrophic consequences to the bottom line of the company. Further the risk is enhanced when the customer might leave after learning that that you sold your business. It may also be a concern when your biggest customers are more loyal to you or your employees rather than the company brand itself. Customer concentration then, is a risk factor to be avoided regardless of the exit path you choose.
Based on our experience many business acquisitions fail due to lack of comfort in mind of the buyer for the ability of target company to maintain the same level of customer base after acquisition. So build a business with a diversified customer base.
We have witnessed cases where companies with growing revenues and cash flows, seemed like an ideal acquisition candidate but its deal price suffered due to the problem that around 80% of its revenue was coming from just 5 customers. When this proposal was taken to the market there was no serious interest especially the price at which seller was willing to sell. Main concern shown by potential buyers is impact on company performance due to loss of even one of those five customers. When the deal was finally closed later, it had a clawback clause of 20% of buyout price in case even one of those 5 customers leave within 2 years from the date of purchase. The business valuation carried from the buyer’s side had trimmed down the purchase price multiple by around 20% below the expected sale price of a comparable business, mainly due to the perceived risk in the deal.
Had the seller expanded customer base instead of focusing on few customers, it would have earned higher premium at the time of sale. Evaluate your company’s customer base through the eyes of a buyer.
2.Ensuring Recurring Revenue and Resistance to “Commoditization”
Imagine that you have a business that has high potential of increasing revenue, what is your immediate reaction? Is it increasing profits and cash flows?
Yes it can be true in businesses at initial days of its introduction of a product line to the market but with recurring or improving revenue, another risk arise which is “commoditization”.
So, what is commoditization?
With the increase in revenue more competitors enter into the market to take advantage of increasing revenue and cash flows and lead to drop in margins.
Many high growth companies initially see surge in revenue but drop in margins due to increase competition. Prices are determined by the interaction of demand and supply. When the demand stay the same but more suppliers enter into the market, prices tend to fall impacting bottom line, so these businesses may still see revenue increasing but profits drop. This is termed as “Commoditization”.
Most of the businesses suffer from this problem. We have seen in past that with increase in oil prices and demand from oil importing countries, new countries and suppliers enter the market such as shale gas extraction in US which lead to increase oil supply, putting pressure on the sale price. This pushed the operating margins to fall even when revenue increased.
There are two value drivers: 1) Recurring, sustainable revenue and 2) having products or services resistant to commoditization.
The importance of recurring revenue as a value driver is evident: As a buyer, anyone would want to acquire a business that prints money with the push of a button. But importantly if the future business model is resistant to being commoditized?
Laws of economics tell us that it’s difficult to create any useful product or service that can’t be quickly imitated and commoditized by competitors. A business model that is on continuous cycle of improvement and enhancement carries less risk of commonization. Thus an attractive business model suggests continuous innovation, segmenting and creating real value-added services.
Not all of these strategies can apply alike to all companies. Selecting the best strategies and incorporating them into your growth plan is critical for the ultimate success of your Exit Plan. Consulting business advisors, fellow owners or an exit planning advisor adds lot of value to enhance the company value and adopting strategies in time.
3.Good And Improving Cash Flow
All buyers look for companies whose cash flow is increasing year over year. For example, there are say 2 companies with both having cash flow of $ 9 million in last 3 years with the difference that company 1 had sales $ 3 million each of last 3 years and company 2 had cash flow of $ 1 million 3 years back, $ 3 million 2 years back and $ 5 million last year. Now question is, which company is worth more in the eyes of the buyer? The natural answer goes to company 2 with growing cash flows. The reason is quite simple that a company with steady record increasing revenue/cash flow can be convincingly projected into future, post-sale growth thereby driving business valuation of the company.
So as a business, before going into an exit strategy, should review the past three years’ annual cash flows. Are they trending upward? If not, review your business model to see if it is in cash flow growth trajectory and thereby improving company valuation. Consulting an exit planning advisor or strategic advisor can be valuable before going into a business sell off.
4.Demonstrated Scalability
A scalable business is one in which profit margins increase as revenues increase. Profit margins increase in such businesses due to the reason that cost does not rise with same value as increase in revenue.
For instance, in professional service firms such as law firms or business consultants, are not highly scalable because their revenues are based on billing rates. So to the increase revenue there is a need to increase the number of lawyers/engineers; in other words, costs rise in tandem with revenue.
Compare that to a business that licenses software to that same law firm—the cost to produce the software, once created, is almost nothing. The additional licensing revenue it receives increases revenue, profit margin, and cash flow.
Evaluating Your Company. Other value drivers such as efficient operating systems and processes, as well as your business model can improve profit margins as revenue increases. Some industries it is easier to do than others but it is possible in most of industries. Think of a company developing a HR software, once it is developed, they can sell the license and scale up the business but it will be difficult for company running a stores where you might always need additional hands to increase operations so revenue is not scalable as easily, however it can still be done by way of standardization of processes and replicating while opening new stores such as done by many coffee brands. Creating a franchisee model as well can make the business scalable.
5.Competitive Advantage
Simply putting competitive advantage is either by offering better products/services or more cheaply. This helps in differentiating from competitors and help improve revenue and cash flows. Most of the times company’s competitive advantage is the reason why customers buy instead of going to competitors.
A good performing business should always assess “what is its competitive advantage and how to improvise on the same?”. Spending quality time in understanding the competitive advantage is one of the important things a business should do to ensure continuity of its business growth. If it is cost than it must focus on keeping it best in the industry. If it is better product then it must substantiate in eyes of ts customers as to why to keep buying its products. If your company has a competitive advantage, there is higher chance of driving a higher valuation.
6.Financial Foresight And Controls
Just like in case of recurring revenue, this value driver also has two aspects.
The first one is financial controls or reporting. Many times good companies are not able to attract buyer’s attention due to lack of reliable financial reporting data, thus confusing potential buyers in identifying real sources of its revenues. Many a times this problem is correctable by taking right business advisors on board who are experts in presenting information from the view of stakeholders. This become even more critical as sloppy financial reporting can indicate to buyers that there’s an underlying problem, the most disturbing could be that owners and management lack a clear understanding of their own company’s financial performance.
The second aspect is that when the company is growing quickly then “how it is fed.” As you create a growth plan for your business, you must project the cash flow cost of implementing it. A business should have enough cash flow to control and sustain the growth cycle of the company which may be from the operating cash flows of the business or by taking external funds from financial institutions. Based on our experience, sustaining high growth need financial support from external parties. Having a firm grip on the financial condition of your company is a critical owner responsibility because, it’s the owner who signs to all the loans and other obligations of the company. It is advisable to employ proper forecasting techniques, with the help of your CFO or a Chartered Accountant, the financial demands that your growth plan will create.
A proper forecasting and securing enough fund flow is important to carry on the expansion spree and improve business valuation of the company.