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In recent posts, I’ve described several value drivers or characteristics that give your business the enduring strength, profitability and increasing cash flow that make it more fun for you to own today and more attractive to buyers some day in the future.

We’ve already discussed:

Today I complete the list with a brief explanation of the other six and offer suggestions about how to evaluate the strength of each in your company .

  • Diversified Customer Base
  • Recurring Revenue That Is Sustainable and Resistance to “Commoditization”
  • Good and Improving Cash Flow
  • Demonstrated Scalability
  • Competitive Advantage
  • Financial Foresight and Controls

Diverse Customer Base

Buyers typically look for a customer base in which no single client accounts for more than 8-10% of total sales. A diversified customer base insulates your company from the loss of a major customer. For example, if your three top customers generate 25-40% of your sales, a buyer will be concerned that one or more of them would leave upon learning that you sold your company. To a lesser extent this may also be a concern to inside buyers if the biggest customers are loyal to you, rather than to the company or other employees. Customer concentration then, is a risk factor to be avoided regardless of the exit path you choose.

Several years ago one of my owner clients decided it was time to sell his $30 million in revenue printing company. It seemed an ideal acquisition candidate because it had both growing revenues and cash flow. But there was one glaring problem: 85% of its revenue came from just five customers.

When the investment bankers took it to market there was no serious interest. Otherwise interested buyers were concerned that the loss of even one of the five customers, and certainly two or more, would seriously reduce revenue and earnings. They passed. When the business finally did sell, the buyer demanded a 35% hold-back and a purchase price reduction if more than one of the five largest customers left within 30 months of purchase. The purchase price multiple was at least 20% below the investment banker’s expectation—due the risk buyers perceived.

Evaluating Your Company.  Had this owner expanded the customer base so that five largest customers were, say, less than 40-50% of the revenue and profitability, the buyers would not have been as risk-averse. Evaluate your company’s customer base through the eyes of a buyer. Without knowing the relationship between company and customers, would you take the risk?

Recurring Revenue and Resistance to “Commoditization”

In the prior post, Your Company’s Growth Strategy: Another Element In Transferable Business Value, we met “Yolanda” the owner of “ABC Co.”. ABC had steadily improved revenue to $8 million, but profits were decreasing. This is a classic indicator that commoditization was occurring in her company’s business niche. Operating margins decreased even as revenue increased.

You may wish to view this as two value drivers: 1) Recurring, sustainable revenue and 2) having products or services resistant to commoditization.

The reason that recurring revenue as a value driver is evident: as a buyer, would you not want to acquire a business that prints money with the push of a button, and will do so in the future because your company’s services and products are resistant to being commoditized?

Yolanda countered the downward drift of her company’s profit margins by taking two important steps. First, she recognized that neither she nor her management team  had the skill sets and experience necessary to change course. Second, she hired a consulting firm and, through them, installed a management team with the higher-level skills and experience needed to create a growth plan that addressed declining operating revenues and accelerating revenue growth.

Evaluating Your Company. First, recognize that it’s difficult to create any useful product or service that can’t be quickly imitated and commoditized by competitors. Second, consider several strategies that enhance recurring revenue and address commoditization.

Scott Barth, a business consultant from Wheat Ridge, Colorado suggests continuous innovation, segmenting, disciplined ranking of A, B, C, D customer types, value-added services, bundling, unbundling, helping customers quantify the value of your company’s solutions, and compensating sales on profit margins vs. sales revenue.

Not all of these strategies will be appropriate for your company. Others, not mentioned by Scott, may be more suitable. Selecting the best strategies and incorporating them into your growth plan is critical for the ultimate success of your Exit Plan. Ask your advisors, fellow owners or an Exit Planning advisor which strategies are the most appropriate for your company.

Good And Improving Cash Flow

Ultimately, all value drivers contribute to good and increasing cash flow, and buyers look for companies whose cash flow is increasing year over year. For example, compare two businesses, each experiencing $6 million of cash flow over the last three years. One company’s cash flow was $1 million three years ago, $2 million two years ago and $3 million last year. The second company had $2 million of cash flow in each of the same three years. Which company is worth more to buyers? The company with growing cash flow. Its track record of steadily increasing revenue can be convincingly projected into future, post-sale growth.

Evaluating Your Company.  Review the past three years’ annual cash flows. Are they trending upward? If not, describe in your growth plan the value drivers that must be strengthened to provide the necessary increases in future cash flow.

Demonstrated Scalability

A scalable business is one in which profit margins increase as revenues increase.  Profit margins increase because costs do not rise in lockstep with increasing revenue. For example, and speaking from personal experience as an attorney, most professional service firms, are not highly scalable because their revenues are based on an individual lawyer’s billing rates. To increase revenue, increase the number of lawyers; in other words, costs rise in tandem with revenue.

Compare that to a business that licenses software to that same law firm—the cost to produce the software, once created, is almost nothing. The additional licensing revenue it receives increases revenue, profit margin, and cash flow.

Evaluating Your Company.  Other value drivers such as efficient operating systems and processes, as well as your business model can improve profit margins as revenue increases. Think about designing a computer app like Angry Birds. There is a fixed cost to design and test, but additional sales do not increase those costs. Yes, scalability is a bit more difficult if you own a hardware store, but not impossible: if your hardware store enjoys high profitability and strong revenue growth, it likely has many of these value drivers in place, including a competitive advantage. If these value drivers can be replicated, you can scale your business by establishing new stores in different locations using the same value driver model. Think: Apple Store.

Competitive Advantage

To paraphrase Michael Porter of Harvard University’s Business School, competitive advantage is the product or service that a company offers—either better or more cheaply—over time than does its competitors. Your company’s competitive advantage is the reason your customers buy from you instead of from your competitors.

Evaluating Your Company.  You may well know your company’s competitive advantage if you have one. If your company does not, you are competing on price alone. In either case, it is worth spending time on this value driver with your management team and advisors. If your company has a competitive advantage you’ll want to protect it and promote it.

Financial Foresight And Controls

As does recurring revenue, this value driver also has two aspects. The first relates to financial controls or reporting.  Many companies lack reliable financial reporting to such an extent that buyers can’t determine what the company has or track the source of its revenues. Usually, this problem is correctable, but it takes time to do so. More importantly, sloppy financial reporting can indicate to buyers that there’s an underlying problem, the most benign of which is that owners and management lack a clear understanding of their own company’s financial performance.

The second aspect is less apparent, but more important.  If your company is to grow substantially and quickly, it “has to be fed.” As you create a growth plan for your business, you must project the cash flow cost of implementing it. Plan at least one year ahead in order to give yourself time to arrange financing if necessary.

Evaluating Your Company. Having a firm grip on the financial condition of your company is a critical owner responsibility because, after all, it’s your signature on all of the loans and other obligations of the company. My suggestion is that you forecast, with the help of your CFO or CPA, the financial demands that your growth plan will create. If growth needs to accelerate substantially and quickly to meet your goals, it may take more than the cash flow of your company to support it. Bank or other financing should be secured before you are in the middle of expansion and find yourself running short of cash.

Conclusion

If you think that these value drivers apply only to businesses considerably larger than yours, such is not the case. Owners must work to make their value drivers strong or companies both large and small will stagnate.

What is unique to smaller companies is that growing transferable value to the level you need to attain your goals likely requires skills and experience beyond your pay grade. Most owners, and include me in that group, need to look to others—next-level management and outside consultants—who have that experience and skill.