Strong financial statements are critical when you are selling your company. They are the basis for any valuation, and the better your revenue mix, margins, and growth rates are, the more profitable and valuable your company will be. Take the time now to focus on each of these elements, and you will see results not only in your current profitability, but also in your value when you decide to sell.
The key categories you should focus on are:
- Gross margins
- Operating expenses
- EBITDA/EBITDA margins
- Working capital
- Capital expenditures
- Financial statements
When potential buyers evaluate your company, one of the first items they will review is your revenue. How fast have you grown historically, and what are your projected growth rates? Equally important is the type of revenue. Is the revenue recurring? Do you have contracts in place? The answers to these questions will impact your value.
Historical growth rate is one of the best indicators of future expansion. You must demonstrate strong, sustainable growth over time. Acquirers will have a hard time offering full value when your company undergoes a surge in growth that increased your revenue to levels you were not close to approaching previously. A track record of consistent and sustainable growth will be more valuable even if you are at your peak.
The mix of revenue is also essential. Recurring revenue under multiyear contracts will be more valuable. Buyers like to minimize risk, and contracts that create certainty about revenue will lead to higher multiples. If you can, secure contracts that will create recurring revenue.
Healthy gross margins are important, but it is all relative to your industry. Compare your margins to industry averages and see where you stand. If you are above average, you are doing something right, and acquirers will reward you for this. If your gross margins are below average, take the time to evaluate your operations and determine how you can increase them. Are there process improvements you can make? Are you managing inventory correctly? Take the time to ask the questions to increase profitability and make yourself more attractive to a potential buyer.
Operating expenses are mostly fixed expenses. It is critical to focus on where to invest and leverage these expenses over time. Many business owners are reluctant to add certain operating expenses since there may not be a direct correlation with an increase in revenue and profit. While we understand the desire to limit overhead, there are suitable investments that will make you more profitable. For example, invest in a good CFO who will analyze your revenue, expenses, and operations to help you become more profitable.
When you are evaluating operating expenses, a good gauge to use is operating expenses as a percentage of revenue. As your company grows, you would expect that percentage to decrease over time. While operating expenses might increase in total dollars, the percentage should decrease as you get more efficient. Acquirers will focus on having the right team in place, but also on managing expenses and preventing an acceleration in these costs.
If you spent the time working on the three previous categories, this one will be easy since it results from the hard work you put into those categories. Demonstrating a growing EBITDA and improving EBITDA margins will show that you have done the work to make your company more profitable. As with gross margins, you will need to measure your EBITDA margins in the context of your industry. Particular industries tend to have high EBITDA margins, while others do not. The higher your margin is relative to your industry average, the more attractive your company will be to acquirers.
Efficient use of working capital creates more cash and limits your investment in current assets and liabilities. It will also demonstrate that your company limits unnecessary investment and allocates resources to other important segments of your business. More efficient use of working capital is attractive to acquirers since it will help generate higher cash flow levels.
Every company has capital expenditures (capex), but the magnitude of these expenditures will help determine the field of buyers. Some are not bothered by the investment in capex, while others view it as a deterrent. Higher levels of capex will lower your free cash flow. Sometimes this can be offset with debt to limit the impact to your cash. Buyers will separate your capex into two categories: maintenance and growth. Maintenance capex keeps your business at your current level of revenue and profit, while growth, as the name implies, helps the company expand. Growth capex will be the area of focus for acquirers. They want to know how much they will need to spend to meet your projections.
When it comes to capex, if you are less than a year from selling, you might want to hold off on a big purchase. You will most likely not get the full benefit of the expenditure in your EBITDA, and the buyer gets the equipment at the close. You will either need to pay the note attached to the equipment at the close or not receive the cash you invested. However, if you really need the equipment, you shouldn’t wait to make the purchase. You still need to do everything possible to grow and do it profitably.
Buyers want to be assured you are presenting your company’s true financial situation. Since most acquisitions require representations that the financial records are prepared according to GAAP (Generally Accepted Accounting Principles) standards, it is wise to confirm this with your accountant.
Most buyers will also conduct a quality of earnings study (Q of E). This due diligence review helps verify your accounting policies and that your financials are prepared to GAAP standards. You might consider conducting your own Q of E to learn of any accounting irregularities before sharing your financials with a buyer. This will allow you time to address the issue before negotiating the purchase price and terms.
With reviewed statements, you have the second-highest level of financial statement preparation, behind only audited financials. Consider having your accountant obtain audited financial statements. Audited statements provide buyers with the strongest level of assurance that your company’s income statement, balance sheet, and cash flow are reported correctly.
Focusing on your financials will pay significant benefits today and when you sell. It is critical that you focus on this fundamental value driver. Strong financial performance will demonstrate to buyers that they are evaluating a company that commands a robust valuation. While this takes some work and expense, you will reap the benefits before and at the time of a sale.
If you have questions about what steps you can take to improve your financial performance, please contact PCE. We have the expertise to help you make these improvements.
This is the second article in our Value Driver series. Click below to explore the other topics.