Transferable value: why do exit planners emphasize it so much? Why is it critical for you as a business owner to know about transferable value? Why should your business have it?
What Is Transferable Value?
Some concepts are best shown by example. Consider two similar companies involved in the same business and have a similar presence. Both have $3 million in EBITDA and approximately $38 million in yearly revenue.
Logically, we would assume that they have the same business value. However, one has very little value, while the other sells for four times its EBITDA because revenue and EBITDA alone do not determine the prices and terms of M&A deals. One company’s higher sales price reflects its ability to sustain operations and grow under new management. That capacity for sustained and improved profit generation after being sold is called transferable value.
If your business decreases or ceases to exist after you depart, it does not have transferable value. On the other hand, your business has transferable value if it sustains and grows after your exit.
Do not confuse transferable value with the profit you make each year. Transferrable value does not reflect how well you run your company but how well it runs without you.
So, transferable value is the value of your business–not for you but the future owner–and what it’s worth to someone else, which makes transferable business value a critical factor in M&A transactions.
What Builds Transferable Value?
Many business owners misunderstand business value as a quantitative science that focuses entirely on financial documents, forecasts, rates of return, multiples, etc. Even though the process of business valuation considers all these factors, it is more qualitative. It has more to do with the future financial situation of the company and its post-transition state.
Why would anyone want to buy your company if it is too dependent on you and would likely show negative returns after your exit? Buyers are not looking for your historical profit statements. They want to see certain traits in your company that will ensure future profitability and growth. We call those traits value drivers. These factors help build transferable value for your business.
Related: Understanding Value Drivers.
5 Top Value Drivers
The main factors that drive transferable value can be assigned to five distinct categories:
- Competent management team
- Strong systems and processes
- Sound financial health
- Large, diversified customer base
- Strategic plan.
1. Competent Management Team
If you are responsible for management and operations, and all new business comes from your personal and industry contacts, your company has little value. To determine if this is an issue for your company, ask yourself:
- If you exit today, will your business continue to run with minimal disruption to cash flow?
- Who will run your business after you leave with minimal disruption to cash flow?
Suppose the answers to those questions depend upon your presence to maintain the business’ profitability. In that case, you need to change your relationship with your business to position yourself to exit the business on your desired terms. This means the first value driver you need is a competent management team who can replace you.
Building that team takes years to find and train the right people with the necessary skills and desired experience to continue growing a company after transitioning to new management. The team also must agree with the terms of the deal and continue working with new management.
2. Strong Systems and Processes
To work efficiently, your management team needs effective systems and processes in place–your second value driver–to shift your business from being an owner-driven company to a system-driven organization. Only well-designed and executed systems can ensure that your company continues to run in your absence. If you tend to micromanage your employees, this will require significant adjustment in your management style and necessitate building trust in the ability of your employees to keep the company running in your permanent absence.
3. Sound Financial Health
To determine the status of your company’s financial health, ask:
- Are all the company’s financial documents clean, updated, and audited by an external CPA?
- What is the state of your company’s financial controls?
- Does your company track industry trends?
- Do you know how your company compares with your competitors concerning profitability, liquidity, and solvency?
- Does your company have access to debt and equity capital?
- How do bank covenant restrictions impact your company?
4. Large, Diversified Customer Base
Suppose a big chunk of your business comes from a single customer, and there is a high probability that customers will leave when you do. This negatively affects a potential buyer’s interest in your business, as the company’s profitability will drastically decline with the loss of that customer.
To build transferable value, you cannot continue to serve a small group of customers. Even with high profitability, it’s not sustainable. To build transferable value, increase your customer base such that no single customer accounts for more than 10 to 15 percent of your total revenue.
Another important element is the quality of the revenue accounts. Having a lot of low-margin customers kills value because that situation does not offer economies of scale. Ensure that majority of client accounts offer high-margin value to improve profitability.
5. Strategic Plan
Finally, you need a strategic plan to bring all the value drivers together and channel them towards your ultimate goal of exiting the business on your terms. A strategic plan defines the direction in which you want to take your company and includes:
- Identifying risks, strengths, and weaknesses
- Analysis
- Value creation initiatives
- Strategies for scaling
- Decision-making
- Allocation of resources
- Plans for execution
- Control mechanisms
- And more!
Buyers want to see the strategic plan for your business because it reveals your company’s future state. It shows that your company is aligned toward growth and profitability and has the internal characteristics to support those goals.
We know that buyers ultimately want to see two things in a company: sustainable profitability and growth.
Concluding Thoughts
We have discussed the top five of the hundreds of value drivers that improve a company’s value to prospective buyers. So, before setting the date of your departure, at least ensure that your company has a competent management team, solid systems and processes, sound financial health, a large and diverse customer base, and an effective strategic plan to build transferable business value.
