EXIT STRATEGIES: Leveraging the valuation

Increasing profitability

If the value of the business is based on the stream of future profit, naturally more is better. However, many owners only think about increasing profits when they finally decide to sell their business. They rapidly cut back expenses in some discretionary areas, reduce overheads where they hope it may not be noticed, cut back on advertising and R&D and trim their personal expenses.

What they don’t appreciate is that the wary buyer is expecting this will happen and is looking for such changes. As soon as they are able to identify this type of ‘window dressing’, they know they will have to dig very deep to discover the real costs of the business.

There is nothing wrong with improving profitability. Many owners are what you might call, ‘asleep at the wheel’ and improvements in productivity and profitability are relatively easy to implement. A business which has been going for many years may well be somewhat lazy at watching expenses, driving sales productivity or managing the right mixture of debt and equity to generate better profits. In fact, the owner may have been living a very comfortable and relatively stress free existence because they were not pushing the business.

This means there is scope for improving profits. Improving profitability is going to take some level of investigation to uncover areas where improvements can be made. Resources and time will need to be allocated to put in place new systems and processes or other changes to effect the desired improvements. You should not think that your profit can be increased overnight. It may take many months, if not years, to put in place the changes needed to substantially improve sustainable profitability. This is an incremental exercise and some gains can be made quickly while others will accrue gradually over time.

When making changes to the business, the crucial question is:

“Is the new level of revenue and expense sustainable?”

This is really the only relevant fact. An owner who decides to put his or her business on the market and systematically work through the business processes to ensure the business is running as effectively and efficiently as possible, has nothing to fear. Providing of course they can show the changes they have made are sensible, reasonable, have implemented standard best practice processes and that the final result is a more profitable and sustainable level of activity.

This is a challenge for the owner.

How do you prove that the changes you made are reasonable and sustainable and were not made solely to push up short-term profits to lift the sale value of the business?

How do you show that the changes will not harm the long-term profitability of the business?

If you don’t have a convincing argument – the result may be a lower EBIT multiple than you otherwise might have achieved and the overall effect might be to reduce the value of the business, not increase it.

I am going to show, in a later chapter, how to undertake changes in a way which can be validated and will prove to be sustainable.

Any change in long-term profitability can have a significant effect on the valuation. Using the data from the earlier example let me show you just how much an impact it can have.

These scenarios show the dramatic increase in value from improving profitability. Using scenario A as a base, a small increase in average profits (B) will immediately impact the NPV. Even a small growth rate in profits (C) can lift the NPV considerably. A larger change in the growth rate (D) can have a dramatic effect.

Scenario B ‘Step Change’ may be achieved by just being more efficient with the use of existing resources. Rent out unused warehouse and office space, sell off obsolete equipment and inventory and be more careful with expenses.

This is not rocket science but simply being more diligent in utilizing assets. You can see a simple step change in profits can have a dramatic impact on overall valuation.

A 10% on-going increase in profits might come from taking advantage of additional business which could be generated from the current customer base.

This might be generated by less than a 10% increase in overall revenue. More attention to customer relationships, cross selling and incentives for staff to work just that little bit harder may be the key to such an improvement. A 10% increase in profits over a 20 year period at a discount rate of 15% would double the NPV. That is, you would double your sale value by increasing net profits year on year by 10% – certainly a target well within the reach of most businesses.

A 20% increase in profits may take more creative thinking but could be achieved through more aggressive selling; some additional sales staff to work with existing customers and acquiring new customers. Even this rate of growth is not dramatic, especially with some investment in innovation to drive it. A 20% increase in profits over a 20 year period at a discount rate of 15% would increase the NPV by a factor of FIVE. That is, you would increase your sale value by five times by increasing net profits year on year by 20%. While this may be a stretch, many businesses achieve this over a number of years.

As you can see, minor improvements in profit growth combined with improving the reliability of the profit forecasts and/or reducing inherent business risks, can move the business from a 50% discount rate to a 15% discount rate and dramatically impact overall valuation (in this 10 year example, SIX times).