(Editor’s Note: Increasing Your Company’s Value: Part 1 - Contracts was in the May 16 issue of Set-Aside Alert)

      This article is the second of a four-part series that analyzes your company from a potential buyer’s perspective, and discusses strategies that you can implement to increase the value of your company.

      The first article discussed how your contracts influence your valuation model. This article focuses on your financial performance.

Buyer’s valuation model

      The financial performance of the company, both historical and projected, serves as the foundation for the buyer’s valuation model. When analyzing financial performance, buyers attempt to answer the question – do they believe that your past performance will be reflective of future performance?

      If so, then historical financial performance will be analyzed and relied upon. If not, the projected financial performance will serve as the basis. Understand, however, that most buyers are skeptical of projected financial performance. This uncertainty translates into a lower valuation.

      The following are some of the financial measures that a buyer looks at when valuing a company:

1. Revenue growth

      Revenue growth is desired by most buyers. However, not all revenue growth is treated the same. Growth that results from your own direct labor or sale of products is worth significantly more than revenue growth going to subcontractors or to other pass-through type transactions.

      Also, organic growth is viewed more favorably than acquisition growth since acquisition growth generally carries a much higher price tag. Having a history of organic growth, along with strong projected growth from contract backlog, would be major factors in increasing your value.

2. Gross and Net Profit

      Gross margin is defined as your revenue less your direct costs of performance. Oftentimes, companies will include the fringe benefits on their direct labor as well as an overhead allocation in this figure.

      The net profit margin is the gross margin less indirect expenses.

      Companies whose gross and net profit margins exceed industry averages make for attractive acquisition candidates. However, this occurs quite frequently in situations in which a smaller company has yet to make necessary infrastructure investments, and thus their profit margins are higher than their peers.

      A buyer would view this situation as unsustainable and would not give you full credit for such superior profit performance because of the infrastructure investment that would be required in the future.

3. Indirect Rates

      Your indirect rate structure must be competitive. Bloated indirect rates reduce the overall profitability of the company but can also substantially reduce the value of the company. The indirect rates must have the ability to absorb additional indirect expenses that will be allocated by the buyer. Running a lean and efficient operation is your best strategy.

4. Cash Flow

      Each month, your typical company pays its employees, subcontractors and vendors for the expenses incurred in that month. These represent the cash outflows for operations.

      The cash inflows are payments received from customers. The quicker the company is able to invoice the customer for its services, then collect the cash, the shorter the overall cash cycle is for the company.

      Companies with short cash cycles and strong cash flows are much more attractive acquisition candidates. The last thing a buyer wants to do after paying a premium to acquire the company is to have to put in additional dollars to fund the ongoing operations of the entity.

5. Strength of Balance Sheet

      There are a couple of characteristics of the balance sheet that a buyer will analyze.

      First is the company’s working capital position (current assets less current liabilities). In most deals, the buyer will require a certain level of working capital to transfer. If the company has less-than-adequate working capital it will be deducted from its overall value while any excess amounts would add to it.

      Second is having a lack of contingencies. A contingent liability, whether recorded or not, will give most buyers heartburn. The fear is that the liability will turn out to be more than what is being carried in the balance sheet or disclosed. This type of uncertainty translates into lower valuations.

      Finally, having an uncomplicated equity structure is preferable. This makes it easier to execute an acquisition without possible hiccups from stock/bond/warrant holders.

Conclusion

      The financial performance of the company will always be the primary determinant a buyer will utilize to value a company. The ability to demonstrate year over year revenue growth and strong profitability will help to maximize the value of your company.

Michael Smigocki, CPA, CVA, ABV is the senior managing director of Federal Strategies Group LLC. He provides government contract and management consulting, M&A advisory, forensic accounting and expert testimony services to the government contracting and technology industries. He can be reached via email at MikeS@FedStrat.com.