Examples:
Each business will have its own way to demonstrate potential growth.
The reliability of that potential will, however, depend on how convincing the evidence is. Here are some examples of how potential could be demonstrated.
A restaurant owner is planning to sell his business but wants to increase the value on sale. He reviews his current business and notes that he has been turning away people on the busy nights and wants to capture this excess demand in the value of the business but knows that, unless the demand can be satisfied, it cannot be incorporated into his future sales forecasts. In reviewing the layout of the restaurant, he notes that the upstairs bar area is not generating the same revenue per square foot as the downstairs dining area. He thus develops a plan for renovating the upstairs area into a further dining area and reducing the bar area. At the same time he reviews the capacity in the other areas of the operation to ensure the extra dining needs can be satisfied.
The final renovation plan requires an investment of $150,000. This includes a new bar layout, decorating and furnishing the upstairs dining room and some additional equipment in the kitchen. He estimates the projected additional revenue from the renovations would add $30,000 net to the business each month. As part of his preparation, he applies and obtains planning permission for the renovation.
The key to this proposal is the validation of the excess demand. This could be done by personal inspection by the potential buyer on the busy nights or by examining the booking sheets. The projections by the restaurant owner need to show both evidence of excess demand as well as a viable plan to satisfy that demand. The additional demand projections could easily add a further $1.25 million to the sales value of the business.
If the excess demand was less predictable, the restaurant owner may need to go ahead with the renovations and show early uptake of the additional facilities. This would produce a sharp increase in the monthly profit but it could be shown that this was a permanent change given the new capacity.
If the full impact over an entire year was not able to be demonstrated, the buyer may discount some of the projected revenue but, even so, a substantial increase in sales price would still be achieved.
A specialist textile manufacturer was considering selling the business. Prior to taking this decision, they had been seriously considering a possible acquisition of a similar business in an adjoining state. The two businesses were of similar size, each generating about $7 million in revenue and about $500,000 in EBIT. Both businesses import cleaning cloths for the catering industry from common suppliers in Asia. They had been in discussions for some time but had not concluded an agreement.
Combining the businesses would result in excess overall warehouse capacity and it is estimated that one of the two major warehouses could be closed with an annual savings of close to $200,000. The overall impact on the sale price of the business could be $1 million.
In preparing the original business for sale, the owner could put up a proposition showing a potential buyer the advantages of acquiring the second business with the subsequent savings, however, a proposal of this nature has high risks associated with it. What if the other business decides not to sell?
What if there are union problems with closing the warehouse? There are simply too many unknowns. While it may make the original business more attractive, it is unlikely to add to its sale value.
If, however, the acquisition deal had been negotiated and an option to buy put in place and a viable plan for warehouse consolidation produced which could be examined by the buyer, the buyer should be willing to add some of the additional projected profits to the value of the business. Of course, if the consolidation had already been achieved, the resultant savings could be proven.
Future profits would then be at a much higher rate than historical ones. The acquisition option could have been more substantiated if the business owner had shown there were several possible target acquisitions and that the potential savings applied to a number of them. If the first acquisition had already been assimilated, a plan to show additional profit growth through replication of
the strategy would certainly add to both the attractiveness of the business as
well as to the potential profit growth.
The founder of a financial planning business is considering selling his practice but wants to generate a higher value than he can justify from his current revenue and profit stream. His business is located along the coast and services local tradesman, retail shop owners and professional practices. In seeking additional revenue and profit opportunities, he has identified a number of strategies:
While all these strategies are possible, it is unlikely that a buyer will pay for unproven potential, therefore the business owner needs to implement each strategy sufficiently to be able to validate the impact of the new activity on the business profitability.
A trial cross-selling project into a sample of clients could prove out the cross selling opportunity and the long term impact on the business could then be estimated. The same approach could be taken with a sample of high net worth individuals. The acquisition potential could be examined by targeting some local practices, doing some due diligence on their practices, identifying the differences in practice profit through benchmarking and then putting selected practices onto an option to buy. If this process had been used in the past to expand the existing business, it would have even greater credibility.
The strategy of opening a new office would be somewhat speculative unless some market research could support the extension to the business. This would have more credibility if an office location had been found and potential staff for the new office had been identified. The impact of an additional planner could be shown by demonstrating unmet demand or long lead times for existing transactions.
Summary
Businesses which have higher growth rates and can demonstrate an increase in profits in the future are able to command higher selling prices. The common way of valuing businesses has been to demonstrate the maintainability of past growth rates as evidence of future potential, however, without supporting evidence, there is nothing to suggest that such growth can be sustained in the future. Most business owners think that they can only prove the capability of the business by showing actual historical profit achievements and that is all they anticipate getting value for. However, potential profit which can be well documented and strongly backed with evidence can provide the basis for a significant increase in sales value.
Building a platform for growth means putting in place the capability to produce additional revenue and profit in the near future, it does not necessitate that the products, processes, rights and activities be fully implemented, only that they can be with a high degree of probable success. While building such capability might incur current costs, the future potential might provide significant returns on such an investment.
The business owner should take time to consider the various ways in which additional future profits could be generated and then consider which activities would need to be undertaken prior to the sale to clearly demonstrate that the potential profits can be readily achieved.
The message here is compelling; potential profits can be drawn into a sales value to the extent that the business can show that the buyer has a high probability of achieving them, even if this requires additional investment into the business.
Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia. A series of free eBooks for entrepreneurs and angel and VC investors can be found at his site here.
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