Decrease the Risk Profile of Your Business

Diversification – Whether we are talking about products, customers or suppliers, it is almost always preferable to diversify. Diversification provides the business alternatives if it is faced with unfavorable external challenges, such as the loss of a large customer, the bankruptcy of a supplier or the entrance of new competitor for a given product line. Of course, such issues may hurt the business’s value, but diversification allows the company to soften the blow. Furthermore, a diversified company is better positioned than its undiversified counterpart to recover from these events more quickly.

Stabilize Revenue and Cash Flow – An investment with a stable, predictable cash flow stream typically suggest a lower risk profile than an investment that has less predictable cash flow and volatile returns. This is why we see much lower rates of return on debt investments (such as bonds) compared to an equity investment. This is not to say that an investment in a company with stable cash flows is more valuable than the riskier, more volatile company based on the fact alone (there are many more factors at play, of course).

Nonetheless, by exhibiting a stable historical cash flow pattern, the company adds reliability and predictability to its risk profile, which decreases the risk associated with an investment, thereby making that investment more valuable and appealing. Stable cash flows are often the result of good diversification. For example, a company that only does snow plowing is susceptible of variability in cash flows based on weather. A harsh winter will bring higher cash flows while a mild winter will result in weak cash flows. However, if the company offers other services, such as landscaping or contract work, the volatility in snow plow cash flows is not as severe to the overall business because of the other revenue streams brought about by diversification.

Build a Strong Bench – Like customer or supplier concentration, many small business have higher risk profiles due to “key man” issues. These issues often stem from a single owner-operator’s far-reaching responsibilities in running the company, and the company’s overall reliance on an owner-operator’s personal relationships with key customers and suppliers. The business can reduce this risk by building an executive management team that can provide stability in all facets of sales and operations should an untimely departure of the owner or other “key man” occurs, whether voluntarily or involuntarily.

A business that can be turned over to a buyer and does not require the seller to keep working in the business will often be worth more than one that is heavily dependent on the seller’s continued involvement. The importance of this issue cannot be understated.  In many cases, a Company having a good management team is the most important factor in the success of any given business transition.  For instance, discussion regarding the quality of the ‘management team’ is one of the primary areas that private equity buyers focus on when considering an acquisition.

Create Repeatable Systems and Processes – Like the three mechanisms we discussed above, the existence of recognized and repeatable systems and processes adds stability to an organization. Companies can insulate themselves from employee turnover by implementing processes that can be easily transitioned among the work-force. In addition, companies that have strong systems and processes typically have more efficient operations, which translate to higher margins and stronger cash flows.

Improve Available Cash Flow

Budgets – spending time to put together month by month budgets each year that are compared to actual results on a monthly basis pays off! This process helps you understand what expenses are actually needed to run the business and helps set revenue targets necessary to achieve bottom line results.  We have found that this simple process can often times help a business owner set and achieve cash flow goals.

Financial Analysis – analyzing how your company compares to its peers within the industry can be a real ‘eye-opener’ for a business owner. There are various sources to find industry data that can be used to create a financial analysis for most any business.  This type of analysis can highlight areas your company is underperforming its peers.  For instance, if the industry data shows gross profit for your business should be 25%, and your business is at 20%, as a business owner you now have identified an area that you may be able to improve your cash flow.

Empowering Your Employees - tailoring employee compensation to productivity or performance-based results, whenever possible, often leads to improved profitability and cash flow. There are many different ways to employ performance based compensation plans, but in its simplest form you set targets for your employees (based in some form on your overall company budget/goals) and if those targets are met your employees make more money and so do you!

Red Herrings

Adjusting Owner Compensation – It stands to reason that if you take less money out of the business in the form of compensation, you will show improved margins and cash flow. This is true. However, a valuator will look at this from the prospective buyer’s perspective and adjust compensation to a reasonable level (based on the services you provide to the business) in determining the company’s value. It should be noted that by reducing your compensation, you are able to leave cash in the business, the result of which might be a stronger balance sheet or an opportunity to invest in new projects, both of which may increase the value of your business. However, simply reducing your compensation without pulling any of these other levers will likely leave your value in the same spot it was in before you adjusted your compensation.

Paying Down Company Debt– This one is a bit tricky because it depends on your perspective. We like to use the analogy of purchasing or selling your home when explaining this concept to our clients. Your mortgage balance has no impact on a value of your home. If you were to pay off your mortgage tomorrow, the most likely sales price of your home would remain unchanged. Furthermore, you have less cash in your pocket than you did prior to paying off the mortgage. What is important to note, however, is that the amount of cash that lands in your pocket when you sell the home will most certainly change because you no longer have to pay off your mortgage.