9 Steps to Increase the Value of a Business Before Its Sale

By Iver Scott, ASA, MSF

Most smaller businesses are worth much less than their owners envision. That is to say, for many small to medium sized businesses, much of their value cannot be transferred to a potential buyer. And buyers will only purchase value that can be transferred.

Before discussing why this is the case, we need to go over the basics of business valuation. At its simplest, the value of a company equals its expected future cash flows adjusted for the risk of not receiving those cash flows. Imagine you have the option of receiving $100 from a software company today or $100 in a year if all goes well for the company, but less if things don’t go well. Most of us would take the $100 today. Why? Because we could invest that $100 in another software company and get a return on our investment. If the average software company delivers a 30% annual return, we’d expect $130 in a year for the risk of investing [or $100 × (1+30%)]. Conversely, given the 30% risk, the promised payment of $100 one year from now is worth just $76.92 today [or $100 ÷ (1+30%)].

The value of a company works the same way. If we expect cash flows of $100,000 per year for the life of the company, we adjust each annual cash flow in the future to its value to us today based on the risk rate (say 30% in the example above).

As you can see, there are two basic inputs to value: cash flow and risk. In the example, if we increase the software company’s cash flow from $100 to $150, the value goes up to $115.38 [or $150 ÷ (1+30%)]. Likewise, if we lower risk, the value also goes up. Adjusting risk down to 25% raises the value to $80 [or $100 ÷ (1+25%)]. Keep this in mind as you read through this article. Every step to increase the value of a business before it sells boils down to either increasing cash flows or decreasing risk.

Turning our attention to creating value, it’s important to consider that a buyer values only the portion of a company that may be transferred. If a portion of the company’s earnings or risk mitigation cannot be transferred, the value will be lower. Further, a buyer won’t pay for strategic ideas unless there is intellectual property in place to ensure their success.

The goal of business succession is to ensure that 100% of the earnings and potential are transferrable and no additional risk will be transferred. With that in mind, there are 9 steps an owner must take before selling the business.

1. Begin The Process Now – Since it takes 3 to 5 years to transform a business so that all parts of its value can be transferred, you and your professional advisors need time to affect a smooth, non-disruptive plan of succession. Last minute patches to a hurried succession plan are obvious to most qualified buyers.
2. Raise Your Revenue Growth Rate – Buyers project future revenue growth based on your historical growth rate. Is there a sound financial reason for doing so? No. But they do it anyway. If over the next three years you can show above-average growth, buyers will assume it’s sustainable for the short term and project higher forward revenue, which translates to higher cash flows and a higher purchase price.
3. Develop Recurring Revenue – Revenues that recur year-to-year are less risky than sales that are won on a one-off basis. Reducing the risk related to revenue increases value. To develop a recurring revenue model you’ll need to do some research and some soul searching. The web is littered with articles about recurring revenue models from multi-year contracts and consumer goods “refills” to Build/Operate/Transfer models and SaaS. Find a way to transform your one time sales to recurring revenue and buyers will sit up and take notice.
4. Increase Profit – Ultimately, buyers will use some sort of profit metric (EBITDA, pre-tax earnings, etc.) to forecast cash flows. As such, an increase in margin goes farther in boosting value than a comparable increase in short-term revenue growth. Here’s why. If your company has $1 million in revenue with a 6% pretax margin of $60,000 and you increase sales revenue 2%, sales will grow to $1.02 million and your pretax earnings rise to $61,200 [or $1.02 million × 6%]. By comparison, if you raise the pretax margin 2% (from 6% to 8%) pretax earnings will jump to $80,000 [or $1 million × 8%].

Increased profits widen the pool of potential buyers by allowing a buyer to finance the acquisition of your company with debt. This results in more attractive offers from a larger group of suitors. For a leveraged acquisition of your company, profits must be positive and maximized as the buyer will use the earnings to fund monthly debt payments.

5. Set The Cruise Control – A buyer looks at your business as a series of systems and processes that convert labor and/or materials into cash flow. As you master, document, and manage these systems and processes, the company’s output volatility and risk diminishes and more output can be realized, increasing cash flows. Your company’s ability to function as a finely-tuned machine that can operate on its own raises its value in the eyes of a buyer.
6. Replace Yourself – Any portion of the business that cannot operate without you cannot be sold unless you intend to work for the buyer. This means when you sell the company, you must be as removed from the business as possible. This includes leadership, technical skills, and relationships. By replacing yourself, you’re demonstrating that your management team and employees can operate and grow the company without you. Start by finding a right-hand person. You will want to develop a plan to keep this person, potentially with some form of compensation that vests along the same time horizon as your exit, and groom him or her to run the company. Then as time and money allow, you can diversify the risk of transferring your role by developing a team to which you slowly allocate relationships and responsibilities.
7. Hire a Reputable CPA Firm – Having the right CPA firm is important for several reasons. First, the buyer needs to judge the accuracy of your financial statements. If the buyer does not have confidence in your CPA firm, the cash flow risks increase and value goes down. This is particularly important if you entertain ideas of selling to a private equity firm or corporate acquirer. Second, a CPA firm with direct experience in your line of business is a key financial and business advisor than can counsel you on revenue growth and recurring revenues, operating inefficiencies and margin improvement, system and process automation, and leadership transition.
8. Do Your Pre-Sale Due Diligence – Contact your top customers and largest suppliers, your CPA, and your attorney to ask about your company’s strengths and weaknesses. If you do your own due diligence before an acquirer does, there won’t be any surprises, and you’ll have time to remedy any issues that arise.
9. Focus On Your Intellectual Property – A buyer will pay a much higher price for products or services that are unique, protected from copycats, and scalable. Unique is self explanatory. Protected from copycats means protected by brand, patent, copyright, or trade secret. What is scalability? It is the degree to which a system or process can enlarge capacity to handle growth. Consider a hamburger franchisor vs. an independent hamburger restaurant. The franchisor can reproduce hamburger restaurants with much less difficulty and cost than an independent hamburger restaurant. Why? Because the franchisor is primarily selling scalable intellectual property (protected brands, trade secret recipes, processes, and a distribution chain) and requires the franchisee to purchase the non-scalable assets (buildings, leasehold improvements, equipment, and personnel).

The transition from tangible assets to intellectual property has the greatest potential to increase your company’s value. What can you do to make your products or services unique, protected, and scalable? Think back to the great ideas you’ve had over the years. Can you establish a best-in-class brand? Can you develop patented or copyrighted processes or products? Can you have software developed that provides your know how and processes to other businesses? Can you franchise your brand and processes? The transition may take years. But find a way and you’ll likely find your company the acquisition target of venture capital or a large corporation.

Whether you intend to sell your business in 3 years or in 20, start the process of intentionally making your company more valuable now. Once you begin, the process becomes easier as you move forward. At the finish line is a company that is wholly salable, maximized in value, and highly sought after by a large pool of buyers.