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Minnesota Technology Magazine - Winter 2007

Net Worth

How and when to start thinking about increasing your business’ value.

BY SARA GILBERT
Elsewhere in this issue, Sara Gilbert wrote about lean manufacturing.

Five years ago, Dick Pedersen met with a business owner who was beginning to think about transitioning out of her company. She wanted to talk about how to plan a five-year exit strategy— including how to build the value of the business before putting it on the market.

“For five years, we’ve been working on driving up the value of the company,” says Pedersen, an MTI business services consultant. “We’ve been [helping the owner improve] the company, making sure that revenue and profits are growing, that operations are improving, and that market share and penetration are improving. Now, right on plan, the company is in the process of being sold.”

This, Pedersen says, is exactly how things should work. But such long-range planning is more the exception than the rule. Most business owners wait to address the subject of value until it’s already time to sell—and by then, it’s too late to make a significant impact. “Value matters when you’re trying to find a buyer for your business,” adds John Connelly, MTI’s director of business services. “But that’s the wrong time to think about it.”

Five years may be the ideal time frame to build a business’s value. But the truth is that evaluating value should be an ongoing process no matter when you’re planning to make an exit. “Even businesses that are planning to continue on as they are should be thinking about improving their value,” Pedersen says. “The things you would do both internally and externally to improve your business and to make it more valuable for a potential buyer are the things you should be doing every day. These are what make your company stronger and more profitable. And isn’t that why we’re in business to begin with?”

The Basics of
Business Valuation

There is no hard and fast formula for putting a figure on a business’s value.“The only real way to see if you’ve set the right value is to put the business on the market and see what happens,”admits Rick Berning,a shareholder in Medina-based Berning & Berning Ltd., which specializes in business valuation.“There’s really no actual formula to follow.” Most valuations apply some type of multiplier to current earnings.The question, then, is how to determine what the multiplier should be. But Berning says it’s almost impossible to come up with a common multiplier, even within industries.“There are rules of thumb for different industries,” he notes.“But even then it’s difficult to say, because every company is so different.” Formulas aside, however, Berning does recommend taking a series of steps and asking certain questions when trying to determine value.

GATHER HISTORICAL INFORMATION ABOUT THE COMPANY
Financial statements go a long way toward proving that a business has a track record of making money and turning a profit.
RESEARCH THE INDUSTRY
Study the competition. Find out everything you can about your market and your customers.“ The customers are a very significant part of the value, ”Berning says. “Are there only one or two, or are there more? And are those customers financially viable? That’s very important to the value of the company.”
DETERMINE HOW MUCH OF THE BUSINESS IS ACTUALLY TRANSFERABLE
Can the business succeed in another owner’s hands? Berning compares a gas station to a brain surgeon as an example.“If the gas station changes ownership,people will still go to it anyway,because the business hasn’t changed,”he explains.“But if a brain surgeon sells his practice, then some of his patients might come in and say,‘Hey, you’re not my doctor.’That business is less transferable.”
LOOK TO THE FUTURE
Specifically, how much cash will this particular business generate in the future? Then, that value needs to be discounted, based on the rate of risk, to a current value.“ You need to predict the future cash flow, then discount that based on the risks for that specific company to come up with a present value,” Berning explains. But even that, he warns, follows no foolproof formula.The discount rate can go up or down based on a number of factors, from how long you’ve been in business to how well you’ve planned for this transition.“If you’ve diversified your customer base and your supplier base, if you’ve come up with a succession plan, then that will likely decrease your discount rate.”
—S.G

GROWTH MODE

The magic word, Pedersen says, is profitability. “When we talk about growth, people often think in terms of revenue or sales volume,” he explains. “But what we really need is to show a growth in profitability. Sales and revenue are issues to deal with that will get you there.”

Increasing profitability is more than a numbers game. To improve profits, a company might try to expand its market share or reach out geographically to capture a larger amount of revenue. If it currently works with only one or two customers, for example, it should try to build its portfolio of clients.

Pedersen compares it to preventative visits to your family physician. Even when you’re feeling well and all your indicators are good, regular checkups may help keep you out of trouble in the long run. The same can be said for keeping a watchful eye on your business’s value. “Even if cash flow is good, you’re making money, and your markets are good, you should still take a preventative approach,” he explains. “Maybe it’s time to look at new products, or new and different market approaches. Maybe you want to improve your Internet presence. You want to make sure that your business stays healthy.”

Even a healthy business can benefit from improving its productivity— sales per employee, perhaps, or per square foot of the facility—by maximizing its resources. That’s where the implementation of lean tools, which focus on eliminating waste and enhancing productivity, comes into play.

“Lean helps you grow because you’re improving the productivity of your organization,” Pedersen says. “That reduces your costs and gives you more capacity so you can absorb additional revenue. When you have good lean techniques, you can be more nimble and respond to your customer needs quicker. Therefore, you have the potential to increase your revenue.”

Examining the effectiveness of your technology solutions can also affect costs, and therefore value. Joe Nemastil, principal of The NT Group, a communications technology company in Plymouth, says that one business he worked with saw its revenues jump from $1.5 million to $4 million after investing in a new communications infrastructure. “Often, you can implement the infrastructure and actually spend less than what you were before,” Nemastil says. “If, for example, you’re leasing a copier/fax/scanning machine for $700 month, but the functions of that machine are not integral to your business processes, you’re wasting money that could be better spent on a custom system designed for your company. Everything needs to be keyed to your business applications.You don’t do technology for technology’s sake— you have to let your business applications drive your use of technology.”

Rick Berning of Berning & Berning Ltd., a Medina firm that specializes in business valuation, agrees that cutting costs plays an important role in increasing the value of a company. “Most people want to increase their revenues; that’s what they focus on,” he says. “But it’s better to cut costs as well. You have to look at the relationship between the two to be successful.”

To find out how MTI's Business Services can help with your business valuation-related issues, click here.

Pedersen likewise warns against focusing too much on revenue alone. If revenues multiply but profits stay flat, something is out of whack. “Maybe they took on too many more costs to create the increase,” he says. “Or maybe they reduced their margins so much that they cut their profitability on each sale. So basically, they bought their revenue. They’ve taken away their profits so that they could get more revenue.”

Connelly agrees that it makes the most sense to focus on earnings when trying to increase value. But at the same time, he says it’s important to be aware of the different risks associated with a business. “The first thing you want to do is enhance the earnings,” he says. “And then reduce risks, anywhere you can. By doing that, you’ll increase the value.”

BIS Seminar:
Business Valuation

Mark your calendars now for April's Business Innovation Series (BIS) event from MTI and the Minnesota High Tech Association (MHTA). The half-day BIS events feature practical content that attendees can put to work immediately. April's BIS event will focus on the necessities of growing your business to create value.

The event will take place on April 11 from 8-11:30 a.m. For more information or to register, click here. Or call MTI at 612-373-2900 or 800-325-3073.

THE POWER OF PLANNING

But just as none of this is a one-size-fits-all solution, it’s also not a one-time-and-you’re-done proposition. The most effective approach is to consider value while constructing the plan for your business—and to constantly revisit that plan to make corrections, adjustments, and revisions.

Connelly sees six key areas that must be carefully considered in the planning process. First come the issues around the market—are you doing everything you can to penetrate the market as much as you can? Then comes technology—including everything from systems to intellectual property. There’s also the organizational structure, the capital available to the company, the energy associated with the business’s mission and its gumption to get there, and finally, the people.

“The people are a big deal,” he notes. “Specifically, how well do you develop and maintain employees across the board? If a buyer were to walk into the business and be able to have a key manager or management team in place, you could definitely establish more value.”

It could easily go the other way as well. Without an established management team or at least a few key players who understand the business inside and out, a buyer may attach significantly less value to a company. “One of the things buyers are going to look at is whether or not there is management within the company that will be able to continue,” Pedersen explains. “Or is the owner of the business the driving force—and will the business fall apart if the owner is not there anymore? That can definitely increase or decrease the value of the company.”

Although it’s tempting to table such issues until it’s actually time to sell, Connelly and Pedersen both urge business owners to address them sooner than later. “Every owner is eventually a seller,” Connelly says. “Maybe not for 20 years, but every owner will be a seller. And there are lots of reasons why—some of which you don’t have a choice about. Things happen. So it’s only logical for every owner and key decision maker to constantly be enhancing the value of the business.”