Secrets of Market Multiples in Valuation
Ever wondered why two seemingly similar companies sell at significantly different multiples? What are buyers considering in ostensibly comparable companies that cause sale price differences? Let’s discuss five key secrets of market multiples:
1. Revenue/Earnings Growth Potential
Buyers are willing to pay more for companies with high growth potential than companies perceived as having low growth potential. The reasons are those high-growth-potential companies:
• create exceptional customer value;
• exploit high-growth market segments;
• are innovative;
• have a strong brand identity;
• create service differentiation; and
• invest in the development and delivery of new or enhanced services.
2. Low Cost and Ease of Scalability
Scalability is a characteristic of a system, model, or function that describes its capability to cope and perform well under an increased or expanding workload or scope.
Buyers are willing to pay more for companies that can scale up easily/quickly and at relatively low cost. Telemedicine and telehealth are examples of strategies that allow for relatively low cost/ease of scalability. Conversely, capital-intensive companies are high-cost/difficult-to-scale businesses that require significant reinvestment once they reach capacity. In addition, they often face physical space limitations that limit growth.
Ways to enhance a company’s scalability include the following:
• use technology to create employee efficiencies;
• focus on reducing/eliminating redundant tasks;
• offer value-added services or develop competitive advantages that increase profits;
• standardize service offerings to reduce capacity constraints; and
• identify ways to access quality candidates for potential new hires.
3. Next-Level Management
Concerning entrepreneurial management, Peter Drucker is quoted as saying that one of its requirements is “… building a top management team long before the new venture actually needs one and long before it can actually afford one.”
That essentially summarizes the importance and appeal of next-level management. Managers come and go, some by their own choice, some forced to do so. But a good company, with strong management in place, can weather the loss of a manager/owner because there are competent individuals available to fill any void. Next-level managers possess the skills and experience to step into key management positions. They may also bring an influx of new, creative ideas that spur growth and help elevate the performance of a company to its “next level.”
Buyers are looking for companies with next-level management to provide that stability and support. Furthermore, next-level managers contribute value in other ways, including:
• enhancing the reputation and clout for the company;
• providing implementation and management of key value drivers;
• increasing strategic industry relationships;
• improving recruitment ability of qualified staff (potentially from the next-level manager’s former company(s));
• boosting accountability for senior management; and
• enriching the ability to reassign managers.
4. Diversified Payor Mix
We’ve all heard the idiom, “Don’t put all your eggs in one basket.” The risk of doing so is that something will happen to the basket and all of the eggs will be broken.
Buyers share a similar perspective when it comes to payors. If a company relies exclusively or heavily on a single payor, the company risks:
• losing the contract;
• lacking leverage during contract negotiations and being forced to accept a less favorable contract;
• limiting payors to public-sector payors without exploring private-sector payors;
• payment delays that significantly affect cash flow; and
• payor audits that lead to disputed claims.
A diversified payor mix can help reduce the impact of these risks. If a company loses a contract, it can fall back on other contracts to drive business. The company maintains leverage during negotiations; if a contract’s terms are unreasonable, the company knows it can walk away from the negotiating table, if necessary, and still have ways of generating revenue. The company can better absorb the negative impact of payment delays associated with a single contract. Finally, a payor audit that creates payment challenges (and possible repayments) is not as likely to cripple the company.
5. Low Company-Specific Risk
Buyers are willing to pay more for low-risk companies than high-risk companies. Low-risk companies tend to be those with:
• regular strategic planning sessions;
• fully engaged competent senior managers;
• fully engaged board of directors or advisory board;
• strong intracompany communications;
• a fostering corporate culture;
• strong customer loyalty;
• barriers to competition;
• good geographic/demographic location(s);
• low customer concentration;
• competent marketing/sales team(s);
• strong brand recognition;
• low employee turnover;
• a continuous learning culture;
• sound quality assurance team;
• effective operations;
• solid finance and IT teams; and
• little or no litigation.
The Bigger Picture
It is quite common for company owners to perceive the market value of their company in terms of market multiples based on prior sales of similar companies. But when comparing themselves to “similar” companies that have sold, they may not be privy to information about matters such as growth potential, scalability, management traits, and company-specific risk of those prior sales (a.k.a., the “secrets” that impact market multiples). Understanding these factors — and knowing how to strengthen them prior to a sale — is critical to securing the best price for your company.
Author David E, Coit, Jr., DBA, CVA, CVGA, CM&AA
If you would like to personally discuss this article, the value of your company, or how to get the best price when you sell it, you can reach David directly at firstname.lastname@example.org or 480.256.0978.