The key financial drivers of ‘value’, being a company’s historical and future revenue, profitability and growth, are no secret. Intriguingly, some companies do not place equal importance on the key non-financial drivers of value.
The foundations of a business, being their policies, processes and systems, are similar (metaphorically) to the foundations of a building and a building is only as good as its foundations.
Businesses often fail to adequately address the following factors that, among others, provide a snapshot of the foundations of a company and are important considerations from a valuation perspective.
Key person risk
When a business loses a key member of staff, for example, the CEO or lead (or head) sales person, there can be a significant impact on the business. This is more common in closely held companies (regardless of size or turnover), where there is little or no distinction between shareholders and management. Whilst restraints and non-compete clauses can reduce the impact of key person risk, companies that recognise and have processes to develop future leaders, institutionalise the knowledge of key people and spread the client and other key relationships to other employees are more attractive acquisition targets. In other words, their foundations mitigate this risk.
Process and systems for corporate governance
‘Value’ and ‘values’ are two distinct words, with different meanings, but they are intrinsically linked in valuations. The ‘values’, being the principles, ethics and behaviours, of a company have an underrated impact on a company’s ‘value’. Many closely held companies lack formal control processes, highlighting an underlying weakness in their foundations. Whilst processes that are more informal may be practically fine for the day-to-day business, from an acquirer’s perspective, the lack of documented procedures and ongoing records increases the level of risk of the unknown and inherently reduces value.
Customer and Supplier concentration
Customer and supplier concentration causes closely held companies to be vulnerable to vagaries in sources of supply or to a particular customer relationship. The “80/20” rule enables a quick, high-level assessment of a company’s customer and supplier concentration risk. For example, an acquirer might consider a company more risky, if 80% or more of a company’s revenue comes from less than 20% of a company’s customers. Companies with solid foundations have policies to address these risks such as supply agreements for major customers and dedicated procurement functions that periodically assess supplier concentration risk.