Maximizing the value of your business through risk-adjusted returns
Are you considering selling your business? If so, it’s essential to understand how to get the most value out of the sale. As someone who has worked with numerous entrepreneurs looking to sell their businesses, I’ve noticed common mistakes that can prevent sellers from maximizing their returns. In this article, we’ll explore these common pitfalls and what you can do to avoid them.
Understanding How Businesses Are Valued
When selling your business, it’s crucial to understand how potential buyers evaluate it. Buyers have a limited amount of capital to invest and many alternatives where they can deploy their capital including other businesses, cash, stocks, or maybe even real estate. The question a buyer is trying to answer is should I invest in this business vs all the other alternatives. This is where the concept of risk-adjusted return comes into play. Risk-adjusted return helps buyers assess whether the expected return justifies the level of risk associated with the investment.
Here are the key components of risk-adjusted return:
Return: This is the profit or gain generated by the investment over a specific period, usually expressed as a percentage or a monetary amount.
Risk: Risk refers to the level of uncertainty or the likelihood that the expected return may not be achieved.
In essence, if an investment is perceived as riskier, buyers will expect a higher return to justify taking that risk. Conversely, if the risk is lower, buyers may accept a lower return.
Calculating Expected Return and Risk
Buyers assess expected return and risk using various factors:
Expected Return: There are two primary ways investors can make returns:
Capital Gains: This is the growth in the value of a company over a specific time frame. Even investors who never plan to sell use a time frame (e.g., 7-12 years). Forecasted capital gains are calculated by subtracting the expected valuation at a set point in the future from the acquisition price. The expected future valuation is based upon the future multiple and future profit:
Future profit is driven by the forecasted revenue growth and margin expansion
Future multiple is driven by the certainty this profit will not fluctuate, and the expected growth rates.
Dividends: When a company generates profits beyond what’s needed for reinvestment, these profits can be distributed to shareholders during the investment period.
Risk: These are aspects which make achieving the expected future value less likely. Generally, the more changes the investor needs to navigate the higher the risk. Example factors include:
Low retention rates: if customers are not returning year after year, this could be a sign of a bad product, industry concerns or a business constantly needing to acquire customers (see below).
Industry Risks: potential changes which can impact profitability such as increasing competition , changes in regulations or technological disruption.
Low profitability: Companies which don’t generate cash profits are more likely to become distressed as they are more likely to make losses if there are unforeseen circumstances such as a recession. Additionally, unprofitable businesses mean that returns solely come from capital gains, not dividends.
Reliance on acquiring customers: Acquiring new customers is inherently riskier than relying on sales to existing customers as more things must go right and it opens you to industry risks.
Operational Risks: These include complicated processes, unreliable products or key-person risks that can add risks to the ability to execute a business plan.
Customer concentration: Having over 25% of your revenue from one customer can increase risk to the buyer as if that customer churns, it can cause the business to enter distress.
The higher the perceived risk, the higher the expected return buyers will demand, which affects the
offer price. For example, given two companies where the business plan leads to doubling profitability in 3 years, however there is an 80% probability of success for company A and a 60% chance for company B, investors will pay more for company A than B. It is also why deals for faster growing companies are difficult, since inherently relying on fast growth increases risks from reliance on customer acquisition and operational scaling.
Maximizing your value
Now that we have understood how investors evaluate businesses, we can present ideas to maximize the offer price for your business:
Increasing expected returns: Though buyers will build a proprietary calculation of expected returns, there are a few actions you can take to help them:
Strong business plan: providing buyers with a detailed and attainable value creation plan will help buyers be more confident in their work, hence the quality of your business. This plan should directly extrapolate your historical performance, not implying any inflections.
Offer seller financing: This increases returns by requiring the buyer to invest less to get the same amount of return. As a seller, you can receive much higher returns (>8%) than you would from other investments.
Earn outs: To reduce the risk to buyers from plans requiring significant growth, sellers can link their payment to the objectives being achieved, explicitly reducing risk to the buyer from execution of the plan, and implicitly reducing risks through proving their confidence.
Reducing risks: As the seller there are many ways to reduce risk including:
Have Contracts: Ensure you have well-documented, long-term contracts with your clients, which reduces the risk of them leaving post-acquisition.
Openness to Equity Rollover: Keeping a minority stake in the business post-acquisition can signal confidence in its future.
Tell a Good Story: Explain your reasons for selling, such as retirement or starting a new venture, to alleviate concerns about negative trends.
Helping buyers understand performance: Buyers care most about profitability, growth, and retention. Financials you share with the buyer may not explain these for example:
Intentional churn of clients due to discontinuing of a product or business model where customers try your product
Personal expenses such as above market salary or expensing personal costs
Forecasted growth – do you have a clear pipeline
Retention and succession plans: Buyers often worry that the founder or key employees have undocumented knowledge or relationships required to run the business. Offering to stay and/or working with sellers to retain these key employees can reduce perceived risk.
By understanding risk-adjusted return and taking these steps, you can position your business for a successful sale that maximizes its value and meets your financial objectives.
If you have any questions, need advice or are looking to sell your business, you can email me at
mo@mkfcontinuity.com