The Basic Formula of Value that Governs What Your Business is Worth
(and Provides Real Insight into Driving Up the Value of Your Business)
Understanding how your business is valued by a potential buyer is a powerful tool that can help you get more for your business when it’s time to sell. In this post, we’ll teach you the one basic formula that governs the value of any business and show you how to leverage this formula to your advantage.
Value = Reward / Risk
When a business is valuated, two variables come into play. How much money is a business projected to make? And what are the risk factors that may prevent this projection from coming true?
High potential earnings are fantastic for boosting business value. Everyone knows this. But what’s not such common knowledge is the important role risk plays in this equation.
Let’s look at three different examples to highlight how this formula works in practice. Note that the examples are oversimplified for clarity.
Example #1: All equal except for income
Imagine two businesses that are exactly the same in every way, except that Business A generates $1.0M in profit every year and Business B earns $500k in profit.
And let's say the multiple for this industry and these businesses is 3x.
All else equal, we can estimate that Business A is valued at 3 x $1.0M = $3.0M and Business B is valued at 3 x $500k = $1.5M.
Should the owner of Business B wish to increase valuation, one thing they could do is to find ways to increase profitability.
Imagine they reach $700k in profits, now the new valuation bumps up to 3 x $700k = $2.1M.
Easy, right? Increase the REWARD and you’ll increase VALUE.
But now let’s add a twist to the picture.
Example #2: One business relies on a single customer relationship
Next, imagine we dive deeper into analyzing the same two businesses and find out that Business A earns 90% of their profit from just one big customer, whereas Business B earns $50,000 each from ten different customers.
What happens if Business A loses that big account? Earnings will drop from $1M to $100k. Ouch!
What if the same thing happens to Business B? Not a big deal. Earnings drop from $500k to $450k. An easy fix.
Because we see that there is a more risk with Business A, the value begins to drop.
So what can the owner of Business A do to prevent the loss of value?
Continuing with this example, one idea could be to diversify their client base and spread their sales out across more clients to reduce the risk in the eyes of a potential buyer. Another option is to use selling strategies (i.e. deal terms) to cover the risk. Typically an "earn-out" is used in this scenario.
As we can see through this example, value is inversely correlated to risk. Increase risk, decrease value. Decrease risk, and you increase VALUE.
Note that relying on too few customers is just one of a long list of risks that can have the same limiting effect on the valuation of your business.
Example #3: One business offers real growth opportunity
Last example.
Let's assume we’re back at square one with the two nearly identical businesses.
Business A is churning along full-steam ahead, kicking butt and doing everything right. Earning $1M per year and valued at $3M (again, using a simplified assumption of 3x earnings; very likely it could be higher).
During the information sharing stage, a potential buyer asks the owner a few questions:
What are the business’ weaknesses? – “No weaknesses. Everything is airtight!”
Where do you foresee new markets for your products? – “No need. We’re already selling to every potential customer!”
What can I do to build upon this business? – “Nothing. I’ve already built the perfect business in every way!”
Sounds like a sweet deal, right? Well, let's look at it from another perspective.
The potential for growth in a business opportunity can have a big impact on valuation and a purchaser's excitement and confidence, as this potential is part of the reward buyers are interested in.
Imagine the owner of Business B answers the same questions:
"Our biggest weakness is that our sales team is underperforming."
"We estimate that we’re only taking 10% of the market share for our region. We have room to expand but just haven’t invested in more equipment to boost capacity."
"We have a couple complementary products and services in the planning stages I can tell you about."
From a purchasers perspective, this business is starting to look attractive because there is significant upside if the purchaser has the ability to improve these "weaknesses."
It’s important to remember that while historical revenues and profit play a big part in valuation, we have to remember that buyers are buying the FUTURE of a business, not the past.
Strategies for driving value
So, going back to our formula [Value = Reward / Risk], we can see that at a very high level, there are only TWO ways to increase the value of your business:
Increase the REWARD.
Decrease the RISK.
Increasing profitability, mitigate risks.
Convert weaknesses into opportunities, and help set up a potential buyer to build a future business that’s bigger and better than the one you’re putting on the market.
These are just a few of the strategies you can engage to establish value and walk away with a bigger payday after closing on the sale of your business.
WANT TO LEARN MORE?
The unfortunate reality of this process is that there is a lot that can wrong, and you only have one shot to get it right... otherwise it can turn into a very costly and unpleasant experience!
Download our report on the "11 Common and Costly Mistakes" people make through the selling process, and set your self up for success from the beginning.
