Three Questions That Can Add Value to Your Business
Views on strategic planning for business usually fall into one of two camps: “couldn't live without it” or “give me a break.” Ironically, those who love strategic planning are most at-risk of over-applying it, while those who see no use for it are potentially leaving the most on the table by not simply defining and refining a strategy that is already working for them. This article outlines an effective approach for both camps to avoid the costs of overdoing or not-doing strategic planning.
The approach involves asking three questions:
Where are we?
Where do we want to be?
How are we going to get there?
Simple? Yes, but that is the point. As a valuation analyst, understanding a company’s strategy is essential to my ability to adequately determine the value of a business. When a company has a written detailed strategic plan, my firm spends a significant amount of time evaluating whether the company’s historical performance and competitive position within their market align with the plan. In other-words, do the company’s past actions align with what it says it will do, and does the company operate in an environment where good execution can lead to the results they seek? That evaluation begins by reframing the strategic plan to answer the three questions.
But, what about when a business does not have a strategic plan? The three questions can provide valuable perspective, without overcomplicating the conversation.
- Answers to the “where are we now?” question help owners think about the current state of their business as a starting point. Do they have the right assets, people, processes, and systems (APPS) in place to grow?
- “Where do we want to be?” helps owners define what the ideal future looks like for themselves and their business.
- “How are we going to get there?” allows owners to design a bridge from the present to the future, discovering along the way what changes will have to be made and risks will have to be taken to reach the other side.
Spending time on the third question with both those that have and do not have strategic plans often results in a re-evaluation of the owner’s vision of the future, and a change in course from one that would have ultimately resulted in a bridge to nowhere to one that is aligned with their objectives.
Let’s go through a scenario that is not uncommon: (Disclosure: I've simplified a lot of the assumptions to cover the main points.) Imagine you own a manufacturing company that generates $20 Million in revenue. You've worked 20 years to build your business; so about $1 Million of revenue growth for each year you've been in business. (Where are you now?) You've never seen a need for strategic planning, because you've built a great business without it. Why fix something that’s not broken?
You love your business, but you're starting to think about what life would look like if your business wasn't at the center of it. You’d like to sell your business in two years for $15 Million, and your buddy told you that most businesses in your industry sell for 0.5x’s Revenue. So, you decide you need to grow your revenue by $10 Million in two years. (Where do you want to be?) That’s five-times more than your historical average (growth of $5MM/year vs $1MM historically). In summary, without any structured planning you have a goal of growing your revenue by 50% in two years to close a value gap of $5MM. How are you going to get there? By any means necessary.
Separately, your estate planner says you should update your estate plan based on your net worth if you sell your business for $15MM. As part of your planning, you need a business valuation report. You decide to engage my firm to perform an extensive valuation analysis, but also to help you determine if selling your business for $15MM will be enough meet your income requirements post-sale. Here are some observations my firm’s analysis brought to you:
- The bad news: We estimate that selling your business for $15MM would leave you with $10MM after you pay down business-related debt and capital gains taxes. The good news: Based on your required income in retirement, net-proceeds of $10MM is enough.
- At current levels of asset efficiency (I.e. $’s of Sales per $ of assets) your business can support $22MM of sales annually. In order to grow to $30MM, you estimate that you will have to invest $1.5-2MM in additional equipment.
- 20% of your revenue is attributable to one client. Most buyers look at anything over 10% as a risk that significantly impacts value.
- Your business is heavily dependent on you for retaining existing clients and bringing on new ones. A buyer would see this dependency on you as a risk that would negatively impact value.
- The product-line you started your business with is your slowest-grower, and about half as profitable as your fastest growing product-line.
- Based on our analysis of private-company transaction databases, your buddy was right: businesses the size of yours in your industry have sold for 0.5x’s revenue – ON AVERAGE. The range of sale prices, however, is 0.3x - 0.7x; a 40% swing in either direction from your expectations. If you just use multiples of revenue as an indicator, your business at $30MM of revenue could sell for between $9MM and $21MM. Businesses at the higher end of the range demonstrated higher profit margins, and lower levels of risk than those at the bottom.
Based on all of that information, your answer to the first two questions hasn't really changed, but “how are we going to get there?” is now drastically different and much more likely to succeed. Here’s how your strategy has changed:
- You decide to focus on increasing profitability and asset efficiency by focusing growth initiatives on your new product line, which reduces the level of sales growth you need to achieve by at least 50% and could mean you don't need to invest in any new equipment.
- You also decide to spend significant time and energy growing clients other than your top one to reduce customer concentration risk, and you decide to hire a director of sales to reduce the company’s dependency on you. Both of these efforts, if successful could reduce your dependence on sales growth by another 40%.
Just based on evidence from transactions of similar companies, simply maximizing profitability and minimizing risk could increase the multiple of revenue a buyer would pay from 0.5x to 0.7x. That would bring your expected sale price to $14MM, which is 80% to your goal of $15MM. Now, any more than $2MM of sales growth will put your net proceeds over and above what you need to live comfortably in retirement off the investment return on your post-sale liquid portfolio.
As I mentioned before, I simplified the situation to be able to focus on the bigger-picture issues. Each business is different, and each business owner’s circumstances exhibit different levels of complexity. That said, the scenario described above closely resembles many of the situations I have seen in my firm’s work with business owners. Getting from “growth by any means necessary” to a more targeted strategy with less uncertainty is what we love to do. I discussed the scenario of an owner planning to exit, but the three questions can also be applied when the owner of a younger business with a longer runway desires clearer visibility into where their business is going if it keeps going like it has.
In most cases business owners think strategically to begin with. Avoiding the definition of a strategy is understandable for a few reasons, chief among those reasons is that it can feel limiting to an owner that values the flexibility that owning a business can provide. The benefit of starting with the three questions is that they are simple, and can be used as a tool to leverage rather than limit a strong vision for the future. When you start to think about how you want to move your business forward, try starting with the three questions and see where it takes you.
Matt A. Morley, CVA, CEPA
Chief Investment Officer