M&A Essentials: Elements of Value — Enhancers and Detractors

In this installment of our “M&A Essentials” series — offering a fundamental understanding of the concepts, issues and processes every business owner should be familiar with when considering and conducting the sale of a business — we focus on the key elements of value and ways to enhance and detract from that value.

As noted in our previous blog on understanding purchase price, shareholders considering a sale of a company should focus on maximizing the cash they receive over time for their investment. Along with maximizing cash flow, it is just as important to minimize risk when it comes to enhancing a company’s value. This two-pronged approach should drive almost every decision in a company preparing for sale, and means clearly understanding what creates value for the business and what detracts from that value. 

Ways to Maximize Cash Flows

It is important to understand that maximizing cash flows does not mean making decisions that would impair current business operations or expose the company to risk. When preparing for a future sale, short-term, mid-term and long-term objectives must be assessed in rationalizing expenditures for the business. 

Make Strategic Investments

If a company is contemplating a sale in three years, then purchasing equipment or making other capital improvements that will boost the company’s sales or reduce costs in the near-term is best. A thorough project finance analysis should be performed to determine the payback period of the purchase or improvement and what the positive impact to cash flow will be. “Ad-hoc” investments made to a company absent a strategic plan can make it difficult to persuade a potential buyer that those improvements will enhance the company’s value, even over time. 

Switch to a Zero-Based Budget

Another way to maximize cash flow is to implement a “zero-based budget” for the company — meaning each department responsible for a budget starts from zero, justifying expenses based on needs and costs rather than historical data. When a company is in a growth phase, it often loses incremental margins because it is making a lot of money but no one is scrutinizing expenses. Take a fresh start look and get lean. Look for opportunities to improve processes and assess if other expenses are necessary for the business’s success. Process improvement may cost dollars up-front, but often achieves significant cost savings in the mid- to long-term. 

Target Working Capital

One additional way to maximize cash flows is to consider focusing more on managing the company’s working capital (current assets minus current liabilities). As a company grows, it generally requires additional working capital to keep operations running smoothly. This means more inventory and an increase in revenues, while payables, or the financial liabilities, often remain the same. However, don’t fall into the trap of bearing the cost of holding all possible inventory at all possible times. Again, strategic decisions must be made to ensure the company has the right inventory at the right time, but doing so can make a significant impact on a company’s value.
 
As a company grows it may make sense to add dedicated resources to accounts receivable collections. With continued growth, also consider opportunities to enhance purchasing power by asking vendors for better terms, such as extending payment terms.              

How to Minimize Risk

American Revolutionary War hero and father of the U.S. Navy John Paul Jones once said, “… those who will not risk cannot win.” While this is true in business, yielding the greatest value for a business means finding an equilibrium of the least amount of risk necessary to achieve the same level of cash flows. Consider the following areas to help minimize risk: 

• Strengthen relationships with key customers. From a cash-flow management perspective, more consistent and increasing sales present less risk than inconsistent or up-and-down sales cycles.
• Decrease competition by providing value-added services and/or product niches that complement the company’s core competencies.
• Establish institutional management practices. In other words, to minimize risk and achieve the highest value, the business cannot be tied to one person or a group of founders. Those individuals need to manage the business in a manner in which relationships can be transitioned to others and leadership responsibilities are spread across the organization. This will enhance the company’s value from an investor standpoint.
• Diversify to the extent possible. This includes customer diversification — possibly the most important kind of all — as well as geographic and/or product diversification.
• Ensure regulatory and corporate governance issues are in good order. A prudent buyer will not pay for the company’s existing problems. 

This list is not exhaustive, of course, but represents a variety of risk factors businesses commonly face. Owners should invest the time and resources necessary to critically reflect on the company and identify areas of risk to minimize.
 
 
When it comes to enhancing the value of a company before a sale (and trying to stay away from detractors), the best advice is to plan, plan, plan. Generally, the most successful exits happen when a well-thought-out plan is executed over a period of years in a way that positions the company to grow and flourish, while mitigating areas of risk that can cause the company to lose its momentum, and its value, quickly or even suddenly.
 
Please contact Josh Lefcowitz at jlefcowitz@cohencpa.com or Jim Lisy at jlisy@cohenconsulting.com for further discussion.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.