Merriam-Webster defines an entrepreneur as “a person who starts a business and is willing to risk loss in order to make money." Every entrepreneur would like to increase the value of their business. But exactly what does this mean?
Generally, value is added by increasing cash flow, reducing risk and boosting the business’s growth prospects going forward, and developing a strong management team. A buyer enters a transaction with the mindset that they can improve the target business in one of these three areas. If business owners can make improvements on their own, they can unlock value and reap the benefits for themselves, as opposed to transferring these financial benefits to the new owners.
Let’s dive deeper into the three main ways you can increase the value of your business:
1. Increase Cash Flow
Increasing the cash flow of a business is a difficult task. According to the U.S. Bureau of Labor Statistics, for new businesses started between 1994 and 2015, approximately 20% failed in the first year, and half failed within five years. If increasing cash flow was simple, these failure rates would not be so severe. But it’s not impossible, and it may be the easiest of the three value drivers since it’s somewhat more controllable than risk and growth. Business owners need to focus on cash flow because increased cash flows often benefit them in the form of higher compensation, larger distributions/dividends and ultimately a larger payout upon selling or transitioning the business.
One way to increase cash flows is to reduce expenses. Business owners should have intimate knowledge of their profit and loss statement and should periodically review expenses for ways to cut costs. Business owners should work with their chief financial officer, controller or outside accountant to brainstorm and come up with ways to reduce the expense structure. Industry benchmarks are a good way to pinpoint how a business’s expenses/profitability compare to its peers. This may provide leverage for owners to renegotiate more favorable contracts with vendors.
2. Reduce Risk and Drive Growth
Valuations are driven by the premise that a business is worth the present value of its expected future cash flows. If we dissect this definition, it really boils down to two concepts: risk and growth. You can increase the value of your business by lowering risk and increasing growth. Riskier future cash flows have a greater likelihood of not occurring than those that are perceived to be less risky.
One way to lower the risk of future cash flows is to diversify the sales base. Companies that are dependent upon one or two very large customers are perceived to be significantly riskier than companies with a large number of smaller customers. The loss of a large customer poses a major threat to future cash flows in the first example, while a company with numerous smaller clients can absorb this loss with sales from its other customers. Additionally, an investor in riskier cash flows would require a greater return on their investment, lowering the value of the business.
Businesses must also display growth potential in order to increase their value. This can potentially be achieved by hiring a larger sales force. However, one must be careful not to add sales just to add sales. The additional sales must translate to added cash flows. Business owners would be wise to compensate salespeople based on profit and not necessarily top-line revenue. Addition by subtraction may occur if a business is able to trim unprofitable service lines and focus on growth in the more profitable areas.
3. Develop a Strong Management Team
Lastly, an important way for a business to add value is to have key employees (in addition to the owner or owners) who are essential to the welfare of the business. In general, businesses that are tied to one person are worth less than businesses that have a strong management team in place.
Many entrepreneurs run businesses that have to be lean and mean in the early years, but they fail to train staff over the life of their business. This will ultimately cost them money in the long run because potential buyers want to see a management team in place that can assist with a seamless transition from seller to buyer.
Training a management team can add another benefit to the owner by creating a potential buyer for their business. Sometimes the management team may want to become the business’s new owners; this is more likely when management have been involved in creating the business’s long-term strategy and feel they can continue its success with minimal disruption.
In the end, it’s important for business owners to unlock value so they can maximize the return on their business. While being an entrepreneur involves “risk taking,” business owners must be more concerned with “risk minimizing” to increase the value of their business. Improving cash flow, increasing growth potential and investing in strong management teams generally result in lower risk and higher valuations.
“Entrepreneur,” Merriam-Webster, https://www.merriam-webster.com/dictionary/entrepreneur, accessed May 29, 2018
“Business Employment Dynamics: Entrepreneurship and the U.S. Economy,” Bureau of Labor Statistics, April 28, 2016, https://www.bls.gov/bdm/entrepreneurship/bdm_chart3.htm, accessed June 18, 2018