What is the enterprise value of my business?
Many entrepreneurs ignorant of the importance of the value of the enterprise. Being aware of it is important while undertaking strategic decisions like sale or investment transaction.
We met with a new client who is into the business of HR services with over Rs 100 crore turnover. The performance has been consistent and not affected by the Covid pandemic. Moreover, the company has reasonably well-established governance and internal control practice.
He is looking for an exit strategy through sale. The reason for the sale of the business is apparent. He wants to exit as he is growing old and children have no inclination to carry forward the legacy—a commonly sighted situation in the MSME segment in India in recent years.
We observed that the process to sell the company is very inappropriate. There is no preparation of any documents, no organised thought process, or professional advice on the sale. They tried to seek potential buyers through their friends and relatives. They got a potential buyer through their network and almost agreed on a price. We felt that it was much below its worth.
MSMEs generally do not give enough attention to improving the enterprise valuation before any action like sale, investment etc., instead, they accept whatever the value arrived during the transaction process.
Having devoted one’s entire life to developing the enterprise, assessing how valuable one’s business is should be paramount. Secondly, the valuation of the enterprise need not be linked to the immediate sale. There are many reasons for undertaking valuation.
Reasons to Value Your Business
· To sell your business
· To attract investors
· Buying out the other owners
· Offering employees equity
· To better understand business’s growth
The list can go on as small business owners’ personal and professional lives revolve around their business and potential. While many of the reasons above involve changes in the company or its ownership, personal events such as marital discord, illness of a critical person, the sudden demise of the enterprise, age factor etc., may also influence the valuation.
How to Prepare for a Business Valuation
If you’re conducting a business valuation for informal purposes, you may want to do it independently. However, hiring a professional valuer like a certified valuer registered with the Insolvency and Bankruptcy Board of India(IBBI), Merchant bankers, Chartered Accountants, or Financial Advisors could be a good idea if you need the analysis for more serious matters.
In either case, there are a few steps you can take to prepare for the valuation:
Get Your Financial Documents in Order
Every valuation is going to be based, at least in part, on your business’s finances. Even the market-based valuation method requires your business’s financial information to find suitable comparable to justify the value you will seek.
At a minimum, you’ll want the previous three years financial statements, including the balance sheet, income statement, and cash flow statement. Then, combine these statements to ensure everything is up to date.
Other finance-related documents, such as sales reports and industry forecasts, can also be important, particularly for DCF and market-based valuations.
Organise Other Essential Documents
Depending on your reason for the business evaluation, you may also want copies of your business licenses, permits, deeds, and certifications available, along with any ongoing contracts with insurers, creditors, vendors, and clients.
If you’re looking for business loans, you’ll likely need to share these along with your financials. You can also pull out your bureau report (Ex CIBIL) and present it to show your credentials.
List Additional Intangible Assets
It would help list the business’s tangible assets (such as cash, property, and equipment) on your balance sheet. Some intangible assets may be listed there, such as copyrights or patents. But think about other intangible assets that may be providing value.
An extensive email list, customers loyalty scheme, good rankings in search engine results, engaged social media profiles, and positive online reviews can all help you attract and retain customers. These types of assets could help improve your business’s valuation even if they don’t have a value on its balance sheet.
Identify sustainable competitive advantages.
If sustained for years and decades, every business must have something playing a crucial role in its success. So be aware of such strengths that support your business to be there.
There are also ways to demonstrate the business’s value to potential buyers that don’t rely on the numbers. For example, if you can show how processes and systems are in place that will keep the business running after you leave, buyers may be more willing to agree to a higher valuation.
Or, perhaps you can highlight how your employees are happy and take ownership of their work. Low turnover can save the business money, and responsible employees can make transitioning to new management easier.
Improving Your Business Valuation
Your business’s valuation will depend on how much money it makes, and increasing revenue and cutting costs are the core essentials to improving your valuation. This apart enterprise value is influenced by aspects such as the business prospectus, internal control, governance, business process, HR practice, etc.
The enterprise valuation can be improved by working on various elements listed above. However, it will happen over a while, not instantly.
You may hire a professional to advise you on improving the valuation. Hiring a professional valuer might be an excellent step, as they can give you the current valuation and help you identify your business’s strengths and weaknesses. They may even be able to offer suggestions for improvement based on what they’ve seen work for other companies.
Do a Practice of Regularly Valuing Your Business
Learning how to estimate the value of a company can be important for MSMEs for many reasons. Even if you’re not planning on selling your business or seeking investment, regularly performing a quick business valuation can help you track your progress over time. In addition, taking a deeper dive into the valuation may help you uncover growth opportunities.
Regular exercise of undertaking valuation is a healthy practice. It is a strategic initiative and can benefit the company in many ways. Giving attention to factors that contribute to higher valuation will put the firms on a pedestal and help the firms secure investment at shorter notice if the need arises.
An ill-conceived strategy to sell the company: Prone to legal and other risks
While many entrepreneurs plan to leave the business for a variety of reasons, the strategic approach is essential to make it a successful sale.
Recently, I received an entrepreneur who had trouble coming out of her failed exit plan. The business had been running successfully for many years. However, the COVID-19 pandemic and the consequent lockdowns had a severe impact on the business of the company. The company experienced supply chain disruptions on the one hand and the delayed restarting of orders from some of the customers on the other hand.
In view of advancing age and lack of successor within the family, she decided to quit the business and started exploring someone who can take charge of the business and run it.
She identified a businessman looking for diversification to take over the company. The terms were negotiated. He did his due diligence and assessed the company’s potential. After mutual discussion, it was agreed to enter into a partnership in which he would own 95% and hers would be 5%. Upon signing of the deed of partnership, the manufacturing facility was immediately transferred to new premises (belonged to new owner).
Bonhomie did not last long. Cracks started to appear in the association as they went into business. There were gaps. For instance, execution of personal guarantee of the new partner to bank loan was deferred rather bank permission was not obtained for new partnership arrangement. Consent of the bank to shift the assets were not obtained. With respect to compensation for the current owner, there was no explicit agreement rather it was left to mutual unwritten understanding. There was no formal business transfer agreement. The partnership deed was more forward-looking as if for a new entity than addressing the transitional challenges and issues. Likewise, few other issues began to bother them and in turn lead to friction.
The entire transaction was organised in a very unprofessional way and without a solid legal basis. Above all, the new partner was new to the industry and did not show much interest in learning the intricacies of the business of the company. This lead to a situation of mistrust and one began to blame the other. The partnership came to an end. The seller lost a great deal to relocate the company to new premises and again bringing it back. On top of that, the company suffered a business loss for six months because of the bickering. In the end, she felt associated with the wrong person.
Selling to the Wrong Person:
Accepting the first offer may not be an appropriate choice. This may not necessarily be your best offer. Selling your company at a high price with little or no money upfront with an extended contract can lead you to lose it all. This is what opened in the case discussed above.
Business sales often go bad after the new owner takes over. The new owner may be inexperienced in business, have a closed mind or be a bad leader. The list goes on and on.
When this occurs, the new owner eventually closes its doors and lets the previous owner hold an empty bag.
The steps one needs to take while putting business for sale.
It is fact that many small businesses do not find successors in their families when the children pursue their own interests. There are other reasons such as poor health, premature death of a key individual, partner differences, etc.
In any event, an orderly sale requires certain essential measures, a methodical approach and respect for existing legal and procedural aspects. Following are few steps we suggest:
1. Timeframe for Sale and preparedness
Keep a time frame of one or two years to conclude the sale. This timeframe must be utilized to update financial records, ensure legal compliance, document the processes, etc., to make the business fit to BUY. This will make the transition friction-free and will not cause disruption.
2. Business Valuation
Next, determine your business’s value, to make sure you don’t set a price too high or too low. Identify key strengths & opportunities. Consult a professional for an assessment with a detailed explanation of the value of the company. The document will provide credibility at the requested price and may serve as a gauge for your offer price.
3. Avail service from an advisor
An experienced advisor can bring expertise to manage the sale and also free up your time. They can add value by leveraging their business network to speed up selling.
4. Preparing Documents
Prepare a detailed Information Memorandum including financial records, legal compliance, detailed list of assets, contact list of customers and suppliers, disclosure of potential disputes, etc.
5. Finding a Buyer
Use the trade networks, online platforms, professional advisors to identify the potential buyers. Sometimes your own associates may assist you in finding the buyer.
Once you have prospective buyers, qualify them before letting to start due diligence in terms of financial standing and more importantly suitability of the person to keep the business running.
The sale of the company must not lead to legal hurdles either to the seller or to the buyer. Because it can destroy the business you have nurtured for many years. It is highly recommended to take the assistance of professionals to create the documentation and deliberate every aspect before signing.
For many MSMEs, the sale is a compelling transition strategy. In addition, selling is the means of realizing the value of the business built assiduously over the years.
Assess your options and choose the best choice in the long term interest of the business you nurtured. Ask yourself, is he the best person to buy and run my company? Or, can they quickly connect with the customer base and learn how to market effectively? When the business sale goes as planned, it creates a tremendous opportunity for new business owners and the success continues.
It is saddening to see a business fail after years of success due to the lack of a professional approach to sell the business.
Poorly structured sale of a business may also incur unnecessary additional costs, including commercial, legal, financial and tax issues.
Diversification: A significant transition risk for MSMEs
Many entrepreneurs opt for diversification to mitigate the risks from existing business. However, success depends upon how well it is handled from the beginning.
Recently I had interacted with an entrepreneur who is setting up a new business in an altogether new vertical. His existing business is doing very well. There is enough buoyancy in the order flow and he could almost overcome the challenge from COIVD 19 lockdown. However, having seen the volatility in the business he started exploring the ways and means to mitigate the risk to himself by diversifying into another area which is not sharing the same type and level of risks the present business is witnessing.
During the interaction, I could found his approach was very detrimental to his own interest and there are very chances of harming himself if he takes that route. I would like to summarise in the following points:
- He asked his senior executive to hire a person to prepare DPR (Detailed Project Report). He, in turn, hired a consultant having long years of experience and got the DPR done.
- The entrepreneur did not involve himself during the course of the preparation of the report and the author was asked to submit the final report
- The assumptions were outdated and not reflect the present situation in the industry.
- Strangely the DPR is not exactly aligned to the objectives set by the promoters
- DPR is prepared with an aim to secure the bank loan; not a document to help the entrepreneurs to understand the nuances of new business.
- It does not explicitly say whether it is worth pursing; how is the reward structure for investors.
- No risk analysis from the perspective of the entrepreneur and mitigations they suppose to look at.
- Packed with download from search engines, the DPR does not discuss the technical feasibility to the point of relevance.
Transition Risk for MSMEs
The change is an integral part of the entrepreneur‘s journey. In the normal course within the existing business, these changes are brought in the incremental way to align with new trends, introducing new products as per the customer requirements or compliance the new regulations etc.. It rarely requires external help except for some highly specialised interventions. In any case, the context and expected outcome are well within the comprehension of the entrepreneur. Thus there is little chance of failure due to the changes going to be implemented.
However, it is not the case with entering into a new venture where we have no knowledge or have any expertise. Transition risk is a significant risk for MSMEs. We have studied many MSMEs which have failed during their transitional phase of diversification. We observed the common traits as below:
Hands-on involvement, a hallmark of their success in the first venture is notably missing in the subsequent ventures. It is a fact that the visibility of the leader and the day-to-day involvement of the entrepreneur in the operations is a potential advantage in the implementation of a new venture. We did not see that level of involvement in the proposed ventures among them. It can be attributed to their unwillingness to come out of their comfort zone( of running core venture).
Not enough deliberations, just pursuing ideas; sometimes just fancy ideas- Many a time the strategy of diversification is driven by the irrational perception of the potential of the opportunity presented than validated by the facts and figures. No attempts were made to understand key success factors of the opportunity and how we are placed to capitalise that. The depth of deliberations is very shallow. Low level of preparedness including identifying key risks is quite evident.
No proper financial planning. In some of the projects, surprisingly they have initiated the construction without financial closure leading to midway stoppage of the work. No milestone, or no visibility of date to launch the commercial operations. In almost all cases the financial distress in the new venture just seeped to exiting one resulting in the loss of momentum in the well-run company.
Lack of HR strategy: It is a fact that when a company sets on the ambition of high growth or diversification, what is important is clear and unambiguous HR strategy that creates a sense of assurance and promote willingness among the employees to work passionately for the betterment of the organisation.
Absence of Internal audit: Having vested the responsibilities in the hands of the professionals is not enough. In an employee-driven business environment, there is a need for rigid checks and balances to oversee the performance and mitigate the risks.
Diversification is needed…
Many sectors show some sort of cyclicality of varying degrees. Any business faces a higher risk of a downturn and diminishing revenues when it caters to one product or market. During economic uncertainties, small and medium enterprises are more vulnerable than their larger counterparts to this risk.
Diversification is beneficial for an entrepreneur to secure long-term financial stability. It is prudent to diversify into different products, industries, and markets. This not only helps one to boost revenue but minimize risks associated with business uncertainties.
However, what is important is the degree to which the promoter involves himself in shaping the new entity matter the most to see its success.
We believe that the following measures help to reap the benefit of diversification:
- 360 degrees view of our preparedness and meticulous analysis of the opportunity.
- Entrepreneurs need to study the business plan thoroughly before consenting to it
- Seek independent advisors to help to shape the venture however make a background check to validate their credentials. Give attention to conflict of interest, if any.
- The attention span required will remain as much as in the startup stage of the first venture.
- People make difference: It doesn’t matter how great your products or services if you don’t have great people, and if they are not being led by great leaders then you’re not going to be realising your company or organisation’s full potential. It is possible to groom people for excellence provided if we have a clear HR strategy.
- If you choose to operate through management team it is also necessary to have independent audit (internal & management) of the business on an ongoing basis to get a third party view about the state of affairs in the new entity. The ongoing audit will bring the checks and balances that there will not be surprises and shocks.
The diversification strategy is good to beat the downturn in the existing core business and secure financial stability. However, its success depends upon entrepreneurs approach and policies.
Formalisation- Timing is the challenge for MSMEs
There is clamouring for making MSMEs accepting formal processes than remain informal. However, the choice of timing (to become formal) is a matter of dilemma for many entrepreneurs.
Recently one of the close confident secured a limit of Rs 30 lakhs in the online platform www.psbloansin59minutes.com and it was a matter of intense jubilation for him. On the one hand, it was a great endorsement of his entrepreneurial journey which has witnessed steep upheavals in the past few years and on the other hand he secured stable source of funding for expanding his business.Read more