This article was originally written for my column for Inc. Maginize.
Deceitful valuations are at the core of the fraud ruling on the Trump Organization. I have seen many small-business owners have unrealistic expectations around business values. These owners weren't being deceitful. However, most think blood, sweat, and tears equate to increased business valuation, so they skew their reality of what their business is worth.
I have been a part of three personal acquisitions and several other mergers and acquisitions. These have ranged from my purchasing FinDaily, a SaaS startup with no revenue for $20,000; my wife's acquiring two construction, furniture, and prefabricated interior solution providers, a $100 million-plus deal; and multiple deals in between. Business valuations have varied, ranging from standard valuation calculations to pure speculation. Based on my experience, here are three keys to increasing business value.
1. Valuations are meaningful only if buyers and sellers agree on a price.
I once had a mentor tell me on the $100 million-plus acquisition that formal valuations are worthless for this reason, so do not waste your time on a formal valuation upfront unless required. There are multiple ways to value a business, but the ultimate sale price depends on the terms a buyer and seller reach based on real market conditions. Business owners should focus on improving value drivers rather than fixating on a hypothetical valuation.
2. Maximize cash flow, not minimize taxes.
I have business owners ask me all the time why their buddy can take all these tax deductions, but they cannot. The simple answer is that their buddy is probably playing Russian roulette with the IRS. Buyers want a business with sustainable cash flow, not cute tax tricks. Strong cash flow indicates a healthy business from which a buyer can quickly recoup their investment. So focus on growing your cash flow and set aside the cash you need to pay your taxes because most solid businesses will be spending a decent amount in taxes.
3. Focus on what is driving business value. The four main financial drivers that directly increase business value are:
Solid cash flow: Buyers are looking to quickly return their initial cash outlay. An attractive cash flow comes from having above-industry gross margins, collecting cash faster than you pay out cash, and controlling costs.
Recurring revenue: Buyers want predictable revenue streams. SaaS companies typically get the highest multiples for this reason.
Diverse revenue: Buyers want a mix of services/products and no customer concentrations of 20 percent or more.
Reliable financial reporting and controls: Timely and accurate reporting is vital to measuring and monitoring the above financial drivers. I have seen a multimillion dollar deal fall apart because the seller could not provide my team with a reliable cost allocation for the segment our client was buying. It also pays to have someone overseeing the financials to guide owners on improving their business valuations and mitigating fraud risk.
While business owners may not intend deceit, inflated valuations can sink a potential merger or acquisition. Owners can improve their business value and reach a solid deal by focusing on these three areas and key financial drivers.