There are many ways to arrive at a company valuation.
Popular methods of valuing a company (or business) include reviewing the health of the balance sheet, analysing an accounting measure such as EBITDA or calculating a value based on market share. While purely financial calculations are important, there are other considerations that influence a company valuation.
In this article, we describe three, sometimes overlooked but nevertheless important factors that contribute to a strong business valuation.
- Long-term contracts with customers
- Documented processes and procedures
- Management independence from founder
Long-term Contracts Point to a Bright Future
Businesses, are by their very nature, in a constant state of flux. With pressure from competitors, regulations, logistics, the state of the economy and much more – anything that provides an element of stability is very welcome.
Long-term contracts provide a company with a level of predictable income and security. The importance of winning long-term business cannot be underestimated in a business world defined by constant change.
A long-term contract to supply a product or a service is a strong indicator that company is trusted by their customers. Examples of long-term contracts include recurring consulting fees, ongoing maintenance services, regular repeat orders and rental of property or equipment.
Long-term contracts provide a strong basis for estimating future performance (an important part of a company’s valuation). Sales projections do not have to be based on estimates that could be wildly inaccurate, they are based on signed contractual documents.
With longer term contracts in place company management can plan more accurately. This can lead to greater efficiency and effectiveness of the company. Staff loyalty to the company can increase with greater job security arising from working on predictable, longer term contracts.
When valuing a company, analyse the duration of contracts. The longer the contracts, the greater the commitment of customers to the company and improved stability in earnings.
Process and Procedures – the Unsung Heroes of Business Success
Documented processes and procedures are central to the success of many companies. From fast food restaurants to commercial airlines and from private hospitals to logistics companies. The McDonalds restaurant chain is in many ways defined by the processes and procedures that underpin their business.
Organisations rely on well documented processes to give them a competitive edge in the marketplace. The efficiency they derive from their documented processes is an important part of their valuation.
So how do documented processes and procedures contribute to a company’s value?
- The processes represent the intellectual property of the company and its understanding of how to run its business. A McDonalds restaurant can server a certain number of people every day based on the processes it uses to cook and serve food. This in turn gives incredibly accurate forecasting of costs and revenue for a given restaurant.
- Documenting processes provides potential buyers with a clear idea of how the business works. Of course, there may be elements of process that must remain confidential for competitive reasons. However, documentation of process helps a purchaser better understand the business they are purchasing – and perhaps how they can improve efficiency.
- Adoption of processes and procedures is a sign of a mature mindset within a business. The business has chosen to look for efficiency in their business and ensure their staff follow the procedures.
- Use of documented processes and procedures means there is less reliance on specific people to do specific jobs. This is critical when people leave the company and so does their knowledge and experience. If this knowledge has been captured in the business processes, the business is at far less risk if a particular individual leaves the organisation.
When analysing a company, assess how much value is derived from their implementation of process and procedure. It may be more than you think.
A Strong and Independent Management
History shows that the founder of a company may not be the best person to lead and manage their organisation. The skills and vision required to start a company are not the same as those needed for day-to-day management. Few founders turn out to be great managers.
So, when valuing a company, ensure you clearly understand the relationship between the founder and the management.
For those companies in an early stage of development, the founder may have almost total influence and control, especially if they are responsible for financing the organisation. This may be no bad thing in the early days as the charisma and force of personality of a founder may be critical to the company’s success.
However, an established company should have a management capable of running the business on its own without being reliant on the founder’s direct input. After all, if the founder were to sell the company, the management will no longer have the founder’s input. The management must be strong enough to run the company.
When assessing the quality of management of an organisation, question if they rely heavily on the founder for direction and vision. Ask the question “What is the company valuation if the founder is no longer there?”
As discussed in this article, all three factors refer to the relative maturity of a company.
- Long-term contracts highlight a company whose products and services meet a proven, well-established need and in such a way that customers are willing to commit to longer duration agreements.
- Adherence to proven processes and procedures shows how a company values its own way of doing things and how that should be documented as part of its DNA.
- The management team have the experience and independence to manage the company separate from the influence and direction of a founder.
Individually or together these three factors have a dramatic impact on a business valuation and should be considered as part of any valuation process.