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If your business still needs to become POPI compliant, we can help. Click here for more information

Part 1: Driving business capital value

Posted on 27 May 2021   

As a business owner, when reviewing the success of your business you may look back and think about all the policies and procedures you implemented over the years. These implementations may have been driven by legislative requirements or your desire to build business efficiencies, consistency and value.

With this being said, when was the last time you assessed the extent of the value that these policies and procedures have added to your business? Often as a business owner, it is easy to get lost working IN your business rather than ON your business. In other words, getting lost in the day-to-day operations, as needs arise, instead of focusing on the bigger picture i.e. leading and building a valuable business. There is often little or no time to take a holistic view of the business and to clearly identify what is adding value or destroying value.

Consider the following:

  1. Do you know how much your business is worth?
  2. Do you track whether the policies and procedures implemented in your business increase or decrease the business value?
  3. Do you know how increases and decreases to, recurring fees and commissions impact the business value?
  4. If you had to sell your business today, could you be certain that it would be sold at the highest price possible?

In this newsletter we look at what a business valuation is and identify quantitative and qualitative factors that drive and destroy business value.

What is a business valuation?

A business valuation allows one to assess the business and calculate the capital value it has accumulated. At Masthead, we take several factors into consideration when determining the value of the business. When we conduct a business valuation, we take a holistic view of the business. In other words, we look at a range of quantitative (financial) and qualitative (non-financial) aspects that can impact the value of the business. The main area of focus is the stickiness of the business’ client base, and therefore the probability that revenue generated by those clients will stay in place when the business is bought by someone else.

A business valuation provides a guide to the seller by indicating the value or price they can ask for the business. But, at the end of the day, what the buyer is willing to pay determines the real value. For this reason, we discuss the factors we consider when conducting a business valuation.

Factors that build value and impact a business valuation 

Masthead uses the discounted cash/revenue flow valuation method. Buyers often use this method to project the future cashflows of the business. It helps them determine whether purchasing the business will prove to be a good investment. As a result, capitalising the revenue flow is important.  We take a view that combines quantitative (Present Value of income flows, with some assumptions) and qualitative factors (e.g. state of compliance, risk in the business, CRM system, client contacts, segmentation, business processes, competence, etc.) into account. If these qualitative things are not in place, it will pull the value down. As previously mentioned, one of the key things to bear in mind is client stickiness and what clients expect in order to remain with the new owner, and this, directly translates into income retention.

Quantitative

Ultimately, the most important quantitative factor considered in a business valuation is gross revenue. Below is a list of factors that may impact the gross revenue of a business:

  • The type of revenue, such as recurring versus upfront. It is better to have a combination of the two. If the business only receives upfront revenue, it can negatively impact the business’ cashflow and impact its ability to cover its operating expenses. Whereas recurring/ongoing revenue will ensure that there is consistent revenue which will reduce the stress on the business owner as expenses will be largely catered for.
  • Investment products, insurance products (e.g. short-term or medical aid), premium increases on risk products and any other types of annual increases.
  • Other revenue (e.g. broker fees charged directly to clients, binder fees payable by product providers).
  • Getting involved with unsuitable products or companies where the due diligence does not stack up.
  • Managing your expenses. When projecting expenses we recommend incorporating an emergency fund into your expense budget. This protects the business against unforeseen events, such as COVID-19, which affects cashflow and therefore business continuity. Having money in the bank will help the seller retain the business by ensuring they are able to cover the necessary costs to keep the business operable for the foreseeable future. It ensures that the seller still has a business to sell versus being forced to close the doors of the business. The key focus here is ensuring that revenue comes from reliable companies and products, suitable to your clients’ financial needs. Also, it is critical to keep a close eye on expenses to ensure that the profit and loss line is protected and applicable FSCA financial soundness requirements are met

Qualitative

As mentioned, there are qualitative factors which may impact the quantitative factors, e.g. systems and processes that will increase the value or minimise the chance of reducing value. Here are some examples of qualitative factors to consider. We have included statistics from Business Health which support these factors. Business Health is an independent organisation specialising in customised advice and solutions to the financial services industry:

  • A clear strategy to maximise client retention. Does the client’s relationship sit with the Advisor or does it sit with the business? Will the client leave when the Advisor leaves the business? This is very important to someone who is looking to buy a business as the client income secures business profitability and sustainability, yielding a return on the buyer’s investment.
  • A documented Business Plan and Strategic Objective that provide direction to the business. These practices allow the business to plan where they see the business as a whole in a few years’ time e.g. 3 – 5 years. It also serves as a roadmap to measure progress towards the business’ goals and objectives, whilst implementing remedial action in real-time to ensure the Strategic Objective is achieved. According to Business Health statistics, businesses with a fully documented longer term strategic plan experience a +79% profit increase per principal. Business planning speaks directly to the ongoing review of the business model and is a critical aspect to ensure the business adapts to external changes, and as a result, remains relevant. In a previous article we highlighted the importance of having a Business Plan in place to ensure business profitability and sustainability. If you missed the article, read it here.
  • Planning for unforeseen events. This will keep you abreast of any sudden changes in expenses e.g. a sudden increase in the price of petrol. This can have a dramatic effect on a monthly expense budget, especially if more clients become comfortable to meet face-to-face rather than online. Another critical element is to ensure planning includes budgeting for emergency capital expenditure which ties into the quantitative factor of managing expenses. We have seen how this planning helped businesses to survive and manage costs for the first three months of the national lockdown, and ongoing during the lockdown period. Masthead offers a Financial Management webinar to ensure you have the right financial management tools in place for the financial health of your business. Find out more about this webinar.
  • A documented Risk Management Plan to ensure the business is prepared for any event.  Carefully consider risks e.g. the quality of the Advice Process and increasing client complaints about product performance. Specifically, the extent to which it follows the requirements set out in the FAIS General Code of Conduct. It is important that the documented Risk Management Plan clearly identifies the business risks and provides remedial action on how to mitigate the risks. Identifying the risks creates transparency for a potential buyer. The mitigation measures give comfort to the buyer in understanding that value is not unknowingly destroyed. Regularly assessing business risks, in order to implement relevant controls to mitigate these risks, is a key driver to operational health. It therefore directly influences capital value. To gain a thorough understanding of what the regulator requires of you and how to implement risk management strategies, read more and register for the Risk Management Plan webinar.
  • Consistency of service and continuing to meet client expectations documented in a client Service Level Agreement. Clients will be accustomed to a certain service standard and would expect that the new owner would be able to provide, at minimum, what they are used to. Therefore, should the business be sold, and these standards drop, an unintended consequence might be that clients leave.

Factors that destroy value and impact a business valuation 

We will now discuss a few factors that may bring down the value of your business. These factors include:

  • Cashflow: As mentioned, not securing a recurring and ongoing revenue stream can place the business under financial pressure.
    Solution: A different basis of charging will alter the characteristics of the business toward stability and profitability, building capital value. 
  • Competence: Employees who are not well trained may put the business at risk as they may make administrative errors that may negatively affect the business reputation and client relationships. Not only can they slow down business productivity, but they might also impact the carrying out of business in an orderly and efficient manner which is a requirement as set out in the General Code of Conduct, Risk Management, Section 12 (a). Solution: Constantly ensure a combination of competent people and a culture of focussed client value delivery. This can help in terms of completing tasks such as Product Supplier administration which will save you, the Advisor and/or business owner, time and enable you to spend that time with your clients. According to Business Health statistics, businesses where more than 75% of employees have an up-to-date job description experience a +250% profit increase per principal. The statistics further show that those businesses who conducted their last performance review/appraisal within the last 12 months experienced a +169% profit increase per principal.
  • Showing your work: Providing additional services to clients for free impacts your, and your back-office employees’ available time. This ultimately takes up time from other clients and as such, impacts the value of your business. If the client thinks advice and extended services are free, it will be challenging to deconstruct the ‘product’ and showcase the value for the client. It will also be more challenging to explain how the charges were made up to arrive at the fee structure. Solution: After identifying the client’s needs it is important to immediately set up a Service Level Agreement and discuss the services you will provide at a specific fee. Showing your work, is therefore a key factor to educating clients regarding the value that is received for the fee that is charged.
  • Business model: An outdated business model which has not taken the current needs and challenges of your target market and external business environment into consideration will destroy business value. Not having a grasp of these factors could result in the business being unable to provide your specific target market with suitable solutions or prevent you from responding to the challenges in the target market and the business’ environment. Solution: When last have you taken time to complete a SWOT analysis. A SWOT analysis is an easy exercise to complete by assessing the business’ Strengths, Weaknesses, Opportunities and Threats. We are all experiencing the many changes that have taken effect during COVID-19. Have you stayed abreast? A SWOT analysis will assist you to constantly review your business, back office, people skills and competence to ensure your business is equipped to deliver services as promised. It is also important to ensure you are able to position your business for the future and change with the times e.g. interacting or servicing clients in different ways using technology rather than face-to-face, incorporating tools such as DocuSign or MS Teams as part of your business model. This provides convenience to the client base and shows forward thinking. Masthead offers an informative Business Planning webinar that will help you take stock of your business’ current position. Find out more about this webinar.
  • Advice risk: Without a documented Advice Process that incorporates legislative requirements, the business is at risk of clients complaining to an official regulatory body such as the FAIS Ombud. This complaint may lead to a financial penalty and/or reputational damage. Risks reduce the value of a business. Solution: A documented and repeatable process to provide clients with initial and ongoing advice. This goes hand-in-hand with a documented system to review their portfolios, backed up by evidence, which ultimately reduces the advice risk inherent in the business.
  • Regulation: Non-compliance with regulation influences the price/value. The less the business can show that proper operational and regulatory processes are in place, the greater the risk and the lower the value.Solution: A documented Operations Manual which incorporates both the necessary regulation and shows that clients are at the heart of the business (Treating Customers Fairly) will reduce this risk. We also recommend regular compliance monitoring and that all remedial actions are implemented.  

The value of a business is made up of many factors. Even though business revenue is important, there are many qualitative considerations that may influence revenue retention and ultimately the value of the business. It is important to look at the business as a whole and not see the different components as separate entities. A business valuation may seem strenuous or unnecessary, but it can be very beneficial. It can identify which areas of your business need work and/or which areas are destroying value in your business. As such, it provides an opportunity to increase your business value before potentially selling it, considering a successor, or just making sure that your business model remains relevant. This is especially relevant in an external environment of ongoing change. It may also prevent you from accepting a lower price for your business and render all the hard work you have done over the years null and void. It will allow you to truly know the business’ value and the opportunity to build on it. For this reason, we encourage you to conduct a business valuation.

With our in-depth knowledge of financial advisory businesses and best business practices, we can assess a business and calculate the capital value it has accumulated. To request a valuation and find out what your business is worth, please contact us.

MASTHEAD IS

A national supplier of risk management services to independent financial advisors and other licensed financial service providers (FSPs). Established in 2004, we help our clients overcome their risk management challenges so they can grow and thrive in an increasingly regulated industry. Providing professional guidance and practical support, our team of specialists is passionately committed to delivering tangible solutions.

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Phone:

+27 21 686 3588

E-mail:

 info@masthead.co.za

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