Without any doubt, when it comes to business valuations, profits stand out as the single most important factor. Yet for many medium to large companies, profits can be quite elusive. Even as we land an ever-increasing list of new big deals, oftentimes the costs simply rise up to eat the profits.
As a business buyer, I want to see a reasonable profit. This should be reasonably high as a percentage of turnover. Too close to the bone and a single bad month takes me out. I also want to see that the profit has been stable and ideally growing over time (think years), because this is what I rely upon to secure the Return on my Investment (ROI) over a reasonable period, say 3 years or less.
When profits fluctuate, especially if they spike without a clear strategic initiative to explain it, alarm bells begin to ring. Without the reasoning, I have to assume it’s luck, or something in the market shifted and maybe, just maybe, it’s temporary.
Now don’t get me wrong. I have been able to double profits in a single year for many clients, but I can always back it with a strategic initiative or insight. It’s the result of something we intended to do, which gives a buyer comfort that this upward trajectory could be sustainable and again provide a healthy ROI.
For a great valuation, a few other things are also very important, like the existence of well-developed business processes and systems, reliable and valuable reporting systems and, critically, that this is all self-sustaining and doesn't rely on the outgoing owner.
To properly prepare a business for sale can take years because investors will look at the history; and so you need to start as soon as possible and consistently build towards the exit - well before you want to exit.
But let's get back to that all important profitability number.
Firstly, it's important to fully grasp that not all products or services are created equally. Even if you started with 10 similar items and applied one rule for markup, over time, each will yield a varying amount of net profits. This is because, like most things in business, profits follow the Pareto Principle or the rule of 80/20, meaning that just 20% of what you do contributes to 80% or more of the profits in your business.
Knowing what your 20% is can be more difficult than you think. The 80/20 principle is well described in terms of its results, but even very few 80/20 gurus can actually unpack it and find what drives these results. And even if you do know, do you really focus your efforts to massively increase the sales in this area?
Frankly most don't know what it is, because that's the beauty of 80/20. Its secrets keep well hidden from view, but here are some rules of thumb you can apply:
One: Your core business, yes, that which accounts for 80% of your turnover, is probably not very profitable. This is because everything has been set up to deliver your core. Your premises, staff, processes and systems all revolve around your core and all contribute to the costs of delivering your core.
Sometimes it even costs you money to deliver the core, like my corporate interior design friends, who were made to realise that design was a costly exercise. Being the highest paid skill, requiring expensive design applications and the endless meetings and revisions it takes to get it right, it was nearly impossible to turn a profit from design alone. Really very exciting profits lay elsewhere, almost a byproduct of delivering the core, but this remained undiscovered - until I pointed it out, that is. Could these be lurking in your shadows too?
Two: Big new clients are also not a great source of profits. This one sounds completely counter intuitive, after all, most marketing efforts are geared up to deliver big new clients. But at what cost? Big clients are often lured with a discount, or terms or something similar. They also generally want something unique instead of buying what's on our shelves, and that costs a lot of money to deliver. Let’s not even mention that they know they are the big clients and they tend to push our staff about a bit. No, those shiny, big new clients are bad for profits and as I said upfront, the costs quickly rise to eat up any profits we thought we might earn.
Do these wonderful 80/20 gems of profit exist in your business? Undoubtedly and that is exciting, however, they may remain tantalisingly hidden in plain sight. Over time, I have uncovered many of these in every business across all sorts of industries and when focusing attention on them, delivered true increases in value, many times with less effort and often without a noticeable change in turnover.
And this is how to massively increase value, because where before you may have been getting 3X EBITDA, with the existence of a demonstrable profit building strategy combined with the other factors previously described, this may easily rise to 4 or 5… combined with twice the profit, and you'll end up with at least 4 times the value you started with.
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