ClarityBV Blog

This post is part of a series, “How to Boost the Value of Your Business.”

With apologies to Homer Simpson… To debt: the cause of — and solution to — all of your business problems.

This post has several parts:

1. Pros and cons of using debt financing in your business
2. How to evaluate if your business has high financial risk
3. Action steps to boost your business value by reducing your cost of debt

Business Debt Pros

The upsides of using financial leverage in business are clear.

• It’s not your money
• Fund expansion or acquisitions
• Even out cash flow for seasonal businesses
• Lower cost of capital than equity
• Amplifies success

Business Debt Cons

The downsides of financial leverage are also clear, or should be after everything we’ve seen the past couple of years.

• You no longer control 100% of your business
• Interest rates can be raised, lines of credit dropped, covenants changed, etc.
• Often used to mask operational problems
• Reduces net cash flow and/or eventual sales proceeds to the owner
• Amplifies failure

How Leveraged Are You?

One of the most common ways to measure leverage is the debt to equity ratio. However, in recent years many tools that are more sophisticated have been developed. One of the most popular of the recent tools is the Altman Z-Score, a formula for predicting bankruptcy.

You might be surprised at what it takes to qualify as high-risk. According to the latest Duff & Phelps Risk Premium Report, nearly 25% of public companies fall into their “high financial risk” category. This includes:

• Companies in bankruptcy or liquidation
• Companies with negative 5-year average earnings
• Companies with negative book value
• Companies with debt-to-total capital of more than 80%

The average debt to market value of invested capital (MVIC is debt financing plus equity value) ratio for this high-risk group ranged from 25% to 60%. For companies in the “gray” or “distressed” zone (measured by Z-Score), average debt to MVIC was roughly 50% or more.

Does high financial leverage really make a difference? High financial risk companies pay a higher rate on debt financing. Importantly, high financial risk companies have a higher cost of equity capital (e.g. opportunity cost to the owners) in addition to higher direct financing costs.

Action Steps

Don’t be afraid to talk with your banker. Most bankers I know wish they were able to have candid conversations with their customers and work with them to improve their business. If you’re afraid of your banker, you might need a new financing partner or you have something to hide.

Ask your lender what it will take to eliminate personal guarantees, simplify or eliminate restrictive covenants, reduce your interest rate by 1/4 point, 1/2 point, etc. Develop a plan to meet the targets and demonstrate your ability to manage your business.

Too many business owners run from fire to fire rather than stopping to take an objective look at their operations. Doing so will improve your borrowing relationship, lower your borrowing costs, and ultimately increase the transferable value of your business.

This post is part of a series, “How to Boost the Value of Your Business.”

In our last post in this series, we talked about the dangers of key person dependence. Key person risk is a subset of a larger issue – concentration. Concentration may have been a fun TV game show, but it is a serious issue in business. Think of it as a double-edged sword, with the potential for great gain and great pain.

• Does your business rely on a single customer for much of its revenue?
• Do you depend on a single supplier for a key component of your product?
• Are you a franchisee?
• Do you sell one type of product or service?

If your answer to any of these questions is yes, you are not alone. Many businesses face these issues. (Including us! We have chosen to focus exclusively on business valuation.) Even employees have a concentration problem; they depend on a single customer, their employer.

The Point Is

One should make the decision to concentrate in full awareness of the risks and rewards. If you choose a high risk, high reward option in one area of your life or business, make offsetting choices in other areas.

For example, if more than half of your business comes from a single customer, do not load up on debt. In my corner of the world, we have many companies that depend on the RV industry. The smart managers stash away cash in the good times, like the ant in the fable of the grasshopper and the ants. The “grasshoppers” are now out of business, given the collapse in industry sales the past two years and inability to manage their debt load. (Not to mention the 1,600+ dealerships that disappeared last year because of their franchise/supplier concentration.)

What Can You Do?

If you want to increase the value of your business, take a hard look at your concentrations. One of the reasons large businesses typically sell for higher multiples than do small businesses, is because they have lowered risk through diversification. This is basic portfolio management theory and has broad application beyond your brokerage account.

Try this simple process and repeat it on a regular basis (perhaps annually or quarterly):

1. Ask yourself the question: “What’s the worst conceivable thing that could happen to this company externally?” (Hat tip to Warren Miller, who thinks this is one critical question to ask management in the risk assessment process.)
2. Make a list of the potential fallout if this worst conceivable event were to happen and jot down ideas about how you would deal with it.
3. Pick the best ideas from the list and start working on them as if your business life depends on it, because it probably does!

You may still decide the risk/reward trade-off of a particular concentration is worth it. At least you will be moving forward with your eyes wide open.

This post is part of a series, “How to Boost the Value of Your Business.” You can check out the intro and post index here. As an entrepreneur with frequent bouts of do-it-yourself-itis, the following topic hits close to home.

Key person dependence increases the risk (and lowers the value) of your business.

Many business owners have developed lucrative jobs, but have not developed a transferable business. Transferability of customer relationships, business processes, and a skilled workforce increases the potential value and marketability of a business.

Even if you have no plans to sell your business in the near-term, it pays to put systems in place before you need them. Key owner or manager dependency is not something easily or quickly fixed in most cases. While it can be difficult to let go of control (and entails real risks), the payoff often includes improved results in the short-term and much greater business value in the end.

How do you know if it’s time to sell or start handing over the reins of your business? The New York Times recently posted an article with several good observations, including:

1. It’s not fun anymore.
2. You’re not inclined to invest in growth.
3. You feel your management skills are overmatched.

If you are an owner or a manager making most of the decisions, and your business would collapse without your involvement on a daily basis, you have a dependency problem!

Action Steps

Assuming you want to reduce your key person dependency, following are some steps to take now.

• Schedule a vacation, and then take a longer one. I’ve heard many business owners say how surprised they are to find that their business performs better in their absence! If things fall apart while you’re away, you’ll clearly know what needs fixing.
• Secure the value of your workforce through appropriate employment contracts, such as non-competition and confidentiality agreements. Consider incentive compensation or alternative ownership structures to increase engagement and motivation.
• Evaluate your current team for those who can step up their role through training and mentoring and identify roles that may require hiring new managers who can do their jobs without daily supervision.
• Create a team or non-insider board of directors to hold you accountable for your business objectives.
• Prepare a plan and budget to eliminate the need for personal guarantees in your lending relationships.
• Obtain key person insurance, outline a succession plan, and create a properly funded buy-sell agreement.
• Designate a contingency team to take care of the business in case of your absence, disability, etc. Then, let them start running the business before an emergency hits.
• Make a list of all your business activity or decisions during the past month and assign each task to someone else.

What other ideas or recommendations have you found to be helpful in this area? Do you have any interesting success or disaster stories related to key person dependency in business?

One of the most frequent questions I’m asked is if there are standard multiples to value a business. I’m not aware of a “standard” multiple to value a business, but I can shed light on six things that often influence the value of the businesses we appraise.

1. Build a Team (reduce key person dependence)
2. Concentration, Not a Game (dependence on a few key customers or suppliers is risky)
3. Debt, a Powerful Force (too much or too little leverage is a common problem)
4. Keep it Clean (clear and credible financial reports matter)
5. Size Matters (bigger companies are often worth more than smaller ones)
6. Slow and Steady Wins the Race (growth is good, but can be deadly)

In future posts, we’ll expand on these points with a few simple action steps for each (and update this post with links to the corresponding entries).

If you would still like a rule of thumb or transaction multiples for your business or industry, following are a couple of excellent resources…

• http://www.bvmarketdata.com/
• http://www.bvlibrary.com/ProductServices/psBRGOnline.aspx