Why do business valuations come to different results on seemingly similar businesses? Making a financial valuation gives a gross indication, but a number of adjustments need to be made. There are soft factors in business valuation. Those are the judgment calls that affect the final valuation.
Soft factors are the judgemen calls affecting the mechanical financial valuation
There are hard facts and soft factors in the broad concept of business valuation. This is how they compare to each other:
- The hard-fact is the mechanical financial valuation that comes to a preliminary value of the business. There are different financial valuation methodologies depending on the maturity stage of the business and the availability of financial figures. Why? Because early stage companies like start-ups have limited financial data available whereas a running business has historical and projected financial statements. Regardless of methodology the outcome is the gross value of the business.
- The soft factors are the judgment factors that is 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 include the growth rate, management quality, scalability, and more. These factors either discount the preliminary financial valuation or enhance it.
There are 10 soft factors that affect the valuation outcome of a business.
- Sales traction – a clear momentum in revenue growth is valuable.
- Sales stability – stable and predictable income is deemed valuable.
- Business model – central to any valuation.
- Scalability – automation and a cross-border set up is valuable.
- Branding – perception is everything, according to marketers. It do affect valuation.
- Management quality – key valuation, one of the most important factors.
- Production set up – a value creator or limiting factor.
- Working capital – key to growth capacity, i.e. valuation.
- Investments – well invested or under-invested?
- Net debt – financial flexibility, or not.
So, lets dive in to the judgement calls affecting valuation
These are 10 soft factors that affect the valuation outcome of a business. Keep an eye on these intangible areas and address them in business planning and in daily operations to create value.
Businesses that have 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 have just recently taken off.
No one likes uncertainty. Stable and predictable revenues are more valuable than volatile revenues.
When assessing the value of a business, it’s important to understand how the business model works. 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 revenue, but also current revenue levels, are dependent on continuous customer acquisitions.
Other business model assessments include the level of involvement of partners and sub-suppliers. It can be cost or scale effective but it also means that parts of the value creation is done by someone else. A high revenue level may still lead to low gross or operating profit levels if partners or sub-suppliers have large stakes in the business model.
Second to sales traction, sales stability and the business model comes scalability. How scalable is the business model?
A well-designed online ERP-system is very scalable since the product and production is basically the same for every customer. At the other end, a traditional consultancy business is 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.
Perception is everything. Your customers’ view of you and your business is your brand, and you can be proactive about it.
Be it content marketing on your web page that establish your industry relevance or participating in visible industry projects, fairs or other events. Nursing your brand is of particular importance when attracting new customer relationships. Key decision makers you will never meet are of particular interest in marketing and branding.
People make all 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 at high risk and hence less valuable. A well-organised business with defined processes, roles and responsibilities is more valuable.
Succession planning, including relevant nursing of key individuals, are part of a HR valuation due diligence. How processes are defined, documented and followed in practice is another important area.
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 other advantages such as product development synergies. You will also be in better control of your margin development and of continuous improvement activities.
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.
Managing working capital is extremely important, not least when in growth mode. Growing your working capital requirement will put a strain on your financing facilities. An increased debt level also means your equity value goes down, your net cash for your shares goes down,
A well-invested business has a good chance at being successful long-term (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 valued destructive at a closer due diligence.
Maintenance investments are important and new investments should be designated towards growth or quality.
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, minus the debt level in the company.
A buyer takes not only responsibility for 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 when you sell the business.
Manage your business lean, in particular working capital, keep an eye on expenses and focus a lot on sales volume and margins to limit indebtedness and improve your equity value.
Each business is valued differently. You will maximise your equity value if you manage your businesses prudently with common sense and a focus on the entire business.
For many entrepreneurs, that last part is the most challenging one. 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 attention. Building the right leadership and team is the final advice on value creation and actually a key part when assessing management quality during business valuation.