Tag Archives: Due diligence

Revenue Quality: What Does it Really Mean?

High quality revenue companies are valued higher than low quality revenue companies.  But what does this really mean and why is this? It is simply a question of risk. High quality revenues reduce risk and therefore result in a higher valuation. What are high quality revenues?  Primarily it is about revenue continuity but also diversity and profitability.

Revenue Continuity
Long term customer contracts provide future revenue predictability.  In many cases capital projects will not get financed without long term customer contracts.  But what if you don’t have long term contracts, what else can give an investor or financier comfort that revenues will stick around? Questions that get at this answer include: How much of an “annuity” does your business model have?  What percentage of revenues can be counted on to recur every year?  Is the product/solution mission critical?  Is it embedded in your customers’ businesses?  Are switching costs high?

As an example, cloud based Software as a Service (“SaaS”) solutions such as Salesforce, Workday or NetSuite are often sold on a per seat, monthly subscription basis.  In some cases upfront customization is required and in all cases customers have to learn how to use the new software.  Once customers have adopted such a solution, they will not switch very quickly.  The solution becomes embedded in another business’ processes which results in high switching costs.  As a result, its recurring revenues are usually quite stable.

There are a number of ways to grow recurring revenues; license or lease your product or technology instead of selling it outright, sell products that need periodic supplies or maintenance, sell service or maintenance agreements, franchise, etc.

Revenue Diversity
The greater the customer concentration the greater the risk.  The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a small company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration.  While the growth that it drives will increase value, the associated risk of these revenues will reduce value.

Early-stage companies tend to have only a few customers that make up a large portion of revenues but, over time, they must strive to build a diverse revenue base.   Ideally no customer generates more than 10% of revenues.

If you operate in a low barrier to entry, fragmented market then it will be hard to increase prices and produce sustainably strong margins.  Of course different business models generate different margins.  For example, a grocery business will have a lower gross margin than a cloud based SaaS business which can generate gross margins of over 70%.  Over time, competition will put pressure on margins but under certain circumstances, such as first-to-market solutions, proprietary products and processes or patents, companies can sustain high margins for a considerable period of time.

Most entrepreneurs will say they have excellent customer relationships and that certain customers would not leave them no matter what.  But stuff happens.  Maybe this belief is based on personal relationships which cannot be sold with the business.  There are always opportunities to improve revenue quality, whether it is to extend revenue continuity, increase revenue diversity or to improve margin.  Improving revenue quality should be an ongoing priority for business owners as it is a strong contributor to company value.

Managing Operating Risk To Drive Value

In my previous post I said that if revenues are diversified and sticky then they are characterized as high quality.  A business with high revenue quality is one that will likely be around for some time to come, and is therefore highly valued.  However no business is risk free.  If your revenues are project oriented with little opportunity for repeat business, or you operate in an industry with low barriers to entry, or a people dependent business such as consulting, advertising or staffing, then what can you do to realize as much value as possible?

Mitigate the risks inherent in the business model by focusing on the following:

Differentiate your Product or Service
While at first glance, it may seem hard to differentiate a business in a well established and competitive sector, keeping an eye on consumer trends combined with creative marketing can often carve out a new profitable niche and present a tremendous growth opportunity.  Lululemon Athletica in the apparel sector and Chipotle Mexican Grill in fast food are examples of effective differentiation strategies.

Grow and Strengthen Customer Relationships
Reduce the unpredictability of project revenues by nurturing customer relationships.  If you can show that the same customers use your services several years in a row then you have an argument for revenue predictability.  If that list of customers is more than twenty then you have an argument for revenue diversity. Length of customer relationships is also a good indicator of a high quality product/service.

Focus on Execution Excellence
In a service business, it comes down to attracting and keeping the best personnel in order to deliver service excellence.  Human resources is a complex, multi-dimensional field and should include processes for recruiting, role definition and responsibility, position incentives and benefits, periodic feedback, and documentation and procedures to fill gaps in the case of unexpected departures.

Add Products and Markets
A one product company is riskier than a product line company.  A local company is riskier than one with a multi-national presence.  While it is easy to over-extend yourself, consider managed product and geographical growth to mitigate risk.

Cultivate Multiple Supplier Relationships
Don’t let your business become “captive” to a sole supplier of component parts.  Cultivate multiple supplier relationships to reduce supplier power and dependence.

Improve Profitability
Analyze your profit margin to see where you want to drive your sales — to higher-margin areas.  A trend of improving margins as a result of operational efficiencies and returns to scale will result in a higher valuation.

Protect Intellectual Property
IP can be patented, copyrighted or treated as a trade secret.  Identify the IP in your business and make sure it is protected and properly owned.

Build Your Brand
Spend time on all of the above will build your reputation and your brand.

The following chart summarizes various characteristics that drive company value.

op risks

Operating risk should be addressed by implementing formal processes.  A business with formal processes, systems and documentation reduces the dependence on individual talent and can quickly respond to exogenous shocks.  Items such as Service Level Agreements (“SLAs”), marketing plans, job descriptions, employment contracts, confidentiality agreements, professional codes of conduct, organization charts, etc. institutionalize a business.  Documented processes are transferable value.  Capturing and transferring knowledge will make the business more sustainable and more valuable.

If potential buyers feel that a business has a high risk profile, they will either not buy it, reduce the price they are willing to pay, or make a portion of the price contingent upon the business’s future performance.

What is Due Diligence and What Does it Consist Of?

Due diligence is an investigation of a business or person prior to signing a contract.  More specific to a divestiture, it is the process of verifying the representations made in the CIM and other marketing materials provided to the potential acquirer by the seller.  For example, in a CIM we may state that the seller’s customer contracts have an average life of three years and that no single customer accounts for more than 5% of revenues.  The potential acquirer will extend an expression of interest based, in part, on this information (remember, while the CIM highlights all the facts that drive sustainable value – it still holds back competitively sensitive information).  Business due diligence is the act of examining all of the signed and valid customer contracts and, in this example, confirming that customer contracts do, in fact, have an average life of three years and that no single customer does account for more than 5% of revenues.

A seller should always keep due diligence in mind when thinking about the sale of their business.   We typically provide sellers with a due diligence checklist early on in the process so that they can take the first several months of the process to get organized and assemble the documents.  I would be happy to share a due diligence checklist with anyone interested (just email me).  The  documents required for due diligence include all material signed contracts such as customer contracts, banking agreements, funding contracts, shareholder agreements, employment contracts, as well as resumes, benefit commitments, internal financial statements, receivables/payables aging schedules, capital acquisition and depreciation schedules, tax records, asset listings, articles of incorporation, the minute book, and perhaps software architecture documents, product roadmaps, environmental assessments, historical board presentations, and ultimately customer and bank reference calls.  These are just a few of the items typically included but, generally speaking, it consists of everything material to the well being of the company.  Clients provide us with these documents and we scan them and selectively, and in stages, make them available in a virtual data room to be shared with relevant parties.

Due diligence generally happens in phases.  Some due diligence is performed before exclusivity (i.e. a signed LOI) and most after.  The first phase of due diligence is business due diligence; this is where the acquirer’s executive and accounting teams figure out exactly how the revenue streams and products of the acquirer and target complement each other in order to determine how much they can pay for the target while meeting their own ROI targets.  Legal due diligence occurs during the exclusivity period and will include title searches and other searches to ascertain the target company is a valid company, owning the assets that it purports to own and operating within the regulations of the jurisdiction and that no lawsuits or claims are outstanding.  Once a certain amount of due diligence is completed parties typically initiate work on the purchase and sale agreement.  Sixty to ninety days is a typical timeframe from signing an LOI to closing the acquisition of a straight forward private company.

Finally, after exhaustive due diligence the seller will still be asked to represent that they did not withhold any information such as knowledge of potential lawsuits in a purchase and sale agreement.  In “What Does a CIM Include and How Do You Position It?”, I said: “ CIM must not over-promise or leave less than flattering facts out because it forms the basis of an expression of interest that may turn into an LOI and, ultimately a purchase and sale agreement.  Due diligence verification throughout this process will uncover all of the facts.” From the outline above I trust you will agree with me.