Factors that Affect ESOP Valuation
Business valuations are calculated a number of ways, as outlined in our business valuation blog post here. What’s important to note, though, is that typically an owner who is selling his or her business will want to maximize value. Our goal with this post is to break down the factors that make the largest impact to company valuation.
Recurring revenue / subscription revenue. Recurring revenue gives confidence to the longevity of the business. If there is any way to have recurring / subscription oriented revenue, this will command a higher valuation multiple, which will then result in a higher overall valuation.
Profitability. I have to kind of laugh as I write this, given all the publicity that silicon valley gets. Most people have read about the unicorn tech startups that sold for double- or triple-digit millions pre-revenue, or while running at a loss. Sadly for the remaining 99.5% of business that want to be acquired, running a profit is pretty important. A great way to kind of see this in action is to actually watch the TV show “Shark Tank”. Shark Tank is portrayed as a group of loud investors yelling at businesses that are often very odd and obscure, however, if you watch a few episodes of it, a theme emerges very quickly. The “sharks” are typically financial investors — they are buying or investing in a company to see a return, and ideally sooner than later. It is our experience that most acquirers are doing the same. If you still aren’t sold on this concept, then consider it this way. If company A and company B sell the same thing and have the exact same business, are the same size, and truly all factors are the same, except company A generates a 30% profit margin where company B generates 6%, company A will certainly be valued quite higher.
Growth. Growing companies are healthy and have a bright future, particularly if profitable while growing AND if the company is both aware of and in control of what is driving growth. If you can show your company is growing and explain what specifically you are doing to drive that growth, your company will receive a stronger valuation. The converse is true for flat / stalled growth, as well as companies that are shrinking.
Scalability. An acquirer is purchasing your company to receive a return on his / her investment, and a way to expedite this return is to grow the company faster. If your company has a specific plan, management team, culture, and processes in place to scale the company, then your company will be valued higher. If you do not have these, the acquirer will know that he/she will have to create these, and thus that will incur a discount on your valuation. Factors to really develop for scalability are hiring processes, repeatable workflow a company value chain that is documented, repeatable sales processes for new revenue generation, established culture that sustains with the company’s growth and protects the integrity of the company’s current success, as well as other factors (links to future blog posts). Scaling Up by Verne Harnish outlines several of the predictable revenue milestones of $1m, $2M, $10M, $50M, and $100M+, and the differences in how companies must transform and be prepared to operate differently to grow to these levels, abandoning some of the things that “worked” or were “OK” at smaller company revenues.
Culture. As mentioned above, your company should have a unique identity and position within the marketplace that justifies your existence. Ideally, you have a defined set of core values that you are using to unite your company around a mission statement, which explains why you exist and what your company is about. Hiring, talent management and retention, internal work and efforts, and everything else that the company does should align with these values in a quest to further the mission of the company. Creating these is not an overnight matter, and so if your company doesn’t have these, or you have a set of values that don’t function in the manner described above, we would encourage you to take the time to do this. This post explains the value of why this is so important for scaling the business and thus breaking through growth plateaus. (note: We don’t believe in doing this just to do it, or for the sake of “Kum ba yah”. We believe and have experienced that this is crucial to have in place for effective and frictionless growth.
Unique IP. This can be truly unique technology, a unique solution, a product or process that is patented, or just an approach that is core to your company that both produces a better result when your company is engaged and is absent from competitors.
Brand. Brand strength, particularly for larger companies, commands higher valuation. A strong brand has loyal customers and is not easily disruptive, which has the same value principle as recurring revenue: stability.
Other valuation factors are considered, and in most circumstances, there are factors that are both unique and specific to certain industry segments.
The goal of a company owner, whether there is a plan to sell the company now, later, or not at all, should be to maximize the above. The irony is that the best kind of company to own is one that does the above, and in the event you are approached for a potential sale of your company, if the above are in optimal shape, you can expect top dollar for your company (and really, you shouldn’t accept any less).
If you’re interested in learning about how to calculate your business’s value, we’ve prepared How to Calculate ESOP Valuation.
Finally, a very good reason to consider selling to an ESOP is that the valuation you can command for your firm is often more fair and frankly higher than you would receive via a third party exit. If an acquirer were to approach you and ask to purchase your company, ideally you would already know what it would sell for if sold to employees (including proper and documented justification), and would then use that as a starting point for negotiation.