Understanding Market Value and Enterprise Value in the Growth of Your Small Business

Published by BradyRenner CPAs | December 14, 2019

Most small business owners will need to plan and prepare for the day when a business ownership transition will take place. This transition could happen through a variety of means and methods.

If you are not the only owner of the business but are ready to retire, your fellow shareholders may agree to buy you out. If the firm is a family business, you may arrange a generational transition so that a son or daughter could earn and ultimately achieve ownership as well as leadership over time. In a firm with a large number of longtime employees, an employee buy-out or an employee stock ownership program (ESOP) could be the right solution. But in many, if not most, cases, the solution of choice (or necessity) will be to sell the business to an interested acquirer.

The sale of a business is not like the sale of any other asset. It involves far more fluid factors, a far smaller buyer’s market (in most cases), and a variety of different philosophies and methods employed for both determining the fair sale price of the enterprise, and agreeing on how the transaction will actually take place. One of the challenges small business owners face is preparing for this confusing and highly fickle moment effectively.

In order to avoid arriving at such a critical moment unprepared, business owners can use a disciplined process to plan the growth and development of their companies around key priorities that will optimize their likelihood of success when the time for business exit does arrive. One of the best methods available for preparing effectively is to use the Enterprise Value model.

Understanding Market Value

When you prepare to sell your business, the essential question of course will be the Market Value of the business. The market value is what will ultimately determine the sale price and terms by which the transaction takes place. This is typically determined by coming to a clear Asset Value first.

To do this, add up the value of everything the business owns, including all equipment and inventory. Subtract any debts or liabilities. The value of the business’s balance sheet is at least a starting point for determining the business’s worth. But the business is probably worth a lot more than its net assets. However, once the asset value is determined, a number of factors come into play when setting the market value, including cash flow revenue, profitability and EBITDA. In addition, of course, an enormous factor in determining the market value is the depth and breadth of the market of willing buyers.

Since we can’t predict the nature of the buyer’s market or of the overall economy in the future, our best bet is to focus on strengthening the enterprise in ways that maximize its likely market value in the future. Stripping away the factors we can’t control and focusing on those we can control is what brings us to the concept of Enterprise Value. For our purposes, the term Enterprise Value is being used specifically as a framework for measuring value in a privately held business. The key difference in using enterprise value as a metric is that it is forward-looking, whereas traditional financial analysis looks backwards by evaluating prior performance.

Defining Enterprise Value

The concept of enterprise value was first developed by Chuck Richards, who performed extensive economic research at MIT on the factors which impact the market value of privately held businesses during the exit/transition process. By creating a series of “Private Business Standards”, Richards and his team developed a business analysis model that looks forward by analyzing the potential value of an enterprise against a series of Normalized Trading Ranges.

In essence, the model examined thousands of private business transactions and examined each business against a series of business factors. In this way, it was possible to establish a core set of levers — decisions and investment that consistently had the most powerful positive impact on a company’s ultimate value at sale. Put another way, this model helps answer the question: “If I can’t control economic conditions or buyer behavior when I am ready to sell my business, what factors that I can control will have the greatest positive impact on a successful sale?”

Understanding and Acting Upon the Value Drivers

The result of that analysis was the identification of eighteen value drivers, nine of them external to the enterprise and nine of them internal. The nine external growth drivers are:

1. Growth: Does the business demonstrate consistent, reliable and reasonably predictable revenue growth over a multi-year period?

2. Revenue: How much of the firm’s revenue is stable, recurring, contracted or otherwise able to be relied upon in future years?

3. Brand: Within its market segment or niche, how strong is the firm’s brand, and how much does that brand positively impact sales and margins?

4. Market: Is the market you operate in itself growing, expanding or developing new niches that you can dominate?

5. Barriers: Do your competitors face significant financial, legal or logistical hurdles in entering or expanding in your market?

6. Margin: Does the enterprise demonstrate a strong margin advantage when compared to industry averages?

7. Share: Is your share of the market or niche(s) you serve well-defined, well-positioned and easily protected?

8. Differentiation: Are your products or services sufficiently different in presentation or delivery to your market?

9. Diversification: Do your revenues come out from a diversity of customers, or are you highly dependent upon just a few accounts for a high percentage of revenue?

In addition, the nine internal growth drivers consist of:

10. Company: Is the company’s business model, structure and configuration as a going concern easy for an acquirer to understand and manage?

11. Operations: Are the firm’s operations processes and procedures documented, monitored and effectively managed?

12. Talent: How effectively is the firm able to identify, recruit, acquire, retain and build its base of talent across the enterprise?

13. Finances: Is the firm’s cash flow and financial health in a positive position? Are assets being fully utilized and risks effectively managed?

14. Customers: Are customers satisfied with the company’s products, services and solutions and has this been tracked and quantified?

15. Legal: Does the firm have a history of legal issues or face any outstanding lawsuits? Are legal and contractual matters properly managed?

16. Sales: Is revenue generation systematic, predictable and well-managed using current processes, clearly defined buyers and effective systems?

17. Management: Are key executives, leaders and management positions filled with proven leaders and are they able to be retained during and after transition?

18. Innovation: Does the firm commit effective resources to driving innovation and new product/service development on an ongoing basis?

How You Can Drive Enterprise Value Today

While these metrics are used in the Enterprise Value model, in part, to compare the company against its peers and generate a conceptual enterprise value figure, the real value is in using these drivers as a baseline for driving the company toward success in each of these disciplines. Companies who commit to building strong infrastructure and strategies around the eighteen value drivers have been shown to achieve powerful goals including increasing revenues an average 21.63% and equity value of the enterprise by up to 27% on average.

And the great thing for the small business owner is that you don’t need to utilize a proprietary system or software application to take advantage of the overall benefits that can be achieved by focusing on the eighteen drivers of enterprise value. All you need to do is address them proactively in your business and strategic planning process, and work with your senior management team as well as your accountant, financial advisor, operations lead and legal counsel to implement strategies for success in each of these areas.

Start by benchmarking your business across each of these eighteen areas, then select one or two that show the biggest gaps and one or two that show the biggest potential for positively impacting your business. Then, focus on improvement projects and change initiatives that can help you achieve quantifiable success in each of those areas. Keep doing this over time and you’ll start to feel more confidence in the sustainability and future growth and sale potential of your enterprise.

Photo by Austin Distel on Unsplash