Enterprise value is an amount that represents the entire economic value of a company. In essence, it is a measure of the takeover price that an investor would need to pay in order to acquire a firm. Calculated by adding a corporation’s market capitalization, preferred stock and outstanding debt together and then subtracting cash and cash equivalents, enterprise value is a more accurate reflection of a company’s takeover cost than market capitalization alone.
In order to increase enterprise value says Lou Savett, managing principal of the strategic transaction services group for Gumbiner Savett Inc., it is important to position your company for future earnings growth. “The way to increase earnings is by taking a hard look at your marketplace and seeing to what extent you can expand it,” he explains.
Smart Business spoke with Savett about enterprise value, the importance of having a strong management team in place and how to best preserve the value of a business when in the selling process.
What steps can a company take to increase its enterprise value?
First of all, a company has to make a determination about where they fit in the marketplace. There are wholesalers, retailers, manufacturers and service companies, each of which has a separate group of component ingredients that make them more or less valuable. Underlying all of that is the fact that the enterprise value of a company is almost always determined by some version of discounted future cash flow. If you are able to diversify your market, if you are able to get into areas where there is less price resistance, if you are able to get into rapidly expanding marketplaces, then you are increasing enterprise value because the future cash flows will be greater than they are now. We also know that pricing multiples change with regard to the future components of the company’s vision. If you are not growing then you are unlikely to get a high multiple. If you are growing very rapidly, in a way that people believe will continue, you might get a multiple that is two or three times higher.
What is the main driver that affects the enterprise value of a business?
The main driver will always be earnings and the question will always be: What sort of future earnings will a prospective buyer be convinced can be attained? The higher this number is the better off you will be. Philosophically speaking, there are only two ways to increase a business. One way is to sell the same product to more people. The other, is to sell the same people more products. You need to do both of those things. Wells Fargo Bank, for example, recently bought an investment banking group and a national insurance brokerage company, expanding the services that they can sell to their clients.
How can a strong management team increase enterprise value?
A company needs to take a hard and sincere look at its management. Generally speaking, when we walk into a company there is usually one key person. If you ask that person, he will quickly tell you that the company is what it is because of his efforts. If you tell that to a prospective buyer the pricing multiple will be reduced nobody wants to take a chance on the genius being there forever. On the other hand, if you can say we have a management team that through thick and thin can run this company for its highest and best purposes then the amount of enterprise value goes up.
What role does enterprise value play in succession planning?
Enterprise value comes to the fore with any type of exit strategy because it accurately predicts what the person or group who is exiting will get in the way of benefits. When you do your succession planning, you want to build your enterprise value up to a certain point. For example, let’s say that your succession planning is to put together an Employee Stock Ownership Plan. Your contributions to the plan are in percentages of your capital stock, so if the enterprise value keeps going up, you put less shares in the plan and keep more for yourself. You will get a bigger bang for your buck tax wise if you continue to increase enterprise value while you’re in the midst of succession planning.
How can a business owner best preserve the value of their business when in the selling process?
We advise our clients when they’re in the selling process to bring together their core management group and get them involved in the selling process. If you don’t do that people will get scared that their job doesn’t have a future and either leave to a competitor or make other plans that aren’t in your best interest as a seller. As you move forward in the selling process it is important to determine what to tell your customers and vendors and when to tell them. All of this has to be handled very delicately. If you don’t, and something goes wrong in the selling process, you’re going to lose a lot of value.
LOU SAVETT is managing principal of the strategic transaction services group for Gumbiner Savett Inc. Reach him at (310) 828-9798 or firstname.lastname@example.org.