What's Your Company Worth? Understanding The Industry's Value Drivers By Michael Smigocki, CPA, CVA What drives value in the government contract marketplace? What are the factors that create a situation where one company sells for 1.5 times its annual revenue while another sells for fifty cents on the annual revenue dollar? What are the factors that a buyer consider when reviewing an acquisition target? This article will discuss some of these value drivers and how the strategic decisions you are making today could impact your value in the future. One fundamental principle that you must understand as it pertains to valuation is that of risk. An entity with higher risk will generate a lower valuation. Minimizing the various aspects of risk will serve to improve the valuation metrics of the organization. Keep this concept of risk in mind as you compare the value drivers against your current situation. Financial Performance Valuations of any company, in any industry, are first and foremost driven by the financial performance of the company. The historical and projected profitability of the company, its ability to generate positive cash flows, the growth trend in revenue, profitability and cash flow of the company, the management of its indirect rates and the strength of its balance sheet are among the most important factors that a buyer considers in developing an acquisition price. A company with a history of erratic earnings, inadequate backlog and liquidity, and one wrought with various contingencies (pending or threatened lawsuits, years of outstanding government audits, excessive unbilled receivables, etc.) will see its value reduced significantly from that of its competitors. Company Characteristics The characteristics that make a company unique can also impact its value. First is the depth and quality of the management team. If too much functionality is tied up with one or two principals of the company (as is typical of most smaller entities), this can have a negative impact on its value. This is because the transfer risk (risk of losing business and profitability due to the transaction) is significantly higher with these entities. The niche or focus (or lack thereof) of the company is also important. For small to mid-sized companies, having significant depth in a few areas is preferable to having little depth in many areas. In some instances, having revenue in non-core areas adds little to no value to the equation. Having a diversity of contract platforms available to a possible customer is important. This would include being on a variety of GSA Schedules and agency GWACs. These vehicles provide a buyer with access to these agencies that they otherwise might not have. Personnel with security clearances are the most sought-after persons in the workforce. The scarcity of these individuals and the logjam the government is experiencing in processing the clearances makes these persons invaluable. Making an investment in people, through sponsoring their security clearance process, can pay tremendous dividends for the company in the form of new revenue opportunities and larger valuation upon sale. Finally, the size of a company can affect its value. Larger companies are deemed to have less risk associated with them through the diversification of clients, contracts and capabilities. Contracts/Customers A history of winning recompeted contracts is an indicator of customer loyalty that adds value to a company. Prime contracts are more valued by a potential buyer than are subcontracts. The contract type also affects valuation. Cost reimbursable contracts are good vehicles to recover indirect costs, but their profitability potential is among the lowest of the three primary types and thus they receive the lowest valuations. T&M and fixed price contracts are more favorable as long as the company is able to manage its cost structure and contract performance. The types of products or services that are offered also impact the value. Currently, higher-end information technology, management consulting, network security and software development services are the receiving premiums in the marketplace. Finally, the agencies that the company is performing work for also impacts its value. Those agencies with growing budgets are most sought after. This would include the intelligence agencies, Department of Homeland Security and Department of Defense, among others. Conclusion Understanding the value drivers in the marketplace can have a fundamental impact on the strategic decisions you are making. When performing your strategic planning for the next year, if maximizing shareholder value is a goal, compare the expected results of your strategic efforts against the value drivers to determine if they are aligned. (Michael Smigocki, CPA, CVA, is the senior managing director of Federal Strategies Group LLC. He provides government contract and management consulting, M&A advisory, litigation support and expert testimony to the government contracting industry. He can be reached via email at MikeS@FedStrat.com.)