From Inc magazine, online

Please note, as you read this article, understand that the method of valuing a business can vary while the price remains the same or similar.  In my work at Dakin Business Group, we most routinely speak of discretionary earnings/cash flow to owner, not pre-tax profit as is mentioned herein.

When Growth Decreases Your Company’s Value

By John Warrillow

Top-line growth is great for your ego. But some types of growth can actually make your company worth less.

I’ve just returned from the Inc. 5000 conference in Washington D.C. where I had the opportunity to be part of a panel about exit strategies. The Inc. 5000 celebrates the fastest-growing companies in America, and the enthusiasm in the conference center was impressive. Although these companies deserve our recognition, I left the event thinking that perhaps some attendees were focused on top line revenue growth at the expense of the value of their companies.

At Sellability, we’ve just analyzed the data from business owners who have received their Sellability Score in the last five quarters. We looked at 5,364 businesses and found that the average company that had received an overture from an acquirer was offered 3.5 times their pre-tax profit. When we isolated the businesses that had a historical growth rate of 20 percent or greater, the multiple offered improved to 4.3 times pre-tax profit, or about 20 percent more than their slower growth counterparts.

However, the real bump in multiple came when we isolated those companies that claim to have a unique product or service for which they have a virtual monopoly. The niche companies enjoyed average offers of 5.4 times pre-tax profit, or roughly 50 percent more than the average companies and fully 20 percent more than the companies with more than 20 percent growth.

Nurture your niche

Chasing bad revenue by offering a sloppy array of products and services is common among growth companies. The easiest way to grow is to sell more things to your existing customers, so you just keep adding adjacent product and service lines. But when a strategic acquirer buys your business, they want to be buying something they cannot easily replicate on their own.

Let’s imagine you develop an innovative new braking system that will bring a road bike to a stop 20 percent faster than the existing top-of-the-line braking systems offered by the leading bike component manufacturers–Shimano, Sram and Campagnolo.

You’ve protected your technology and you have a niche group of cycling enthusiasts who buy from you directly through your website. You make $600,000 in pre-tax profit on $3,000,000 of revenue. To grow, you have a few obvious options to consider: find new cycling buffs that want your brakes and are willing to bypass the traditional bike shop channel; get bike shops to carry your brakes; or sell more stuff to your existing customers.

The first option seems like an uphill battle because there are only so many customers willing to install their own brakes. It’s a fiddly job best done by a bike shop mechanic.

Option two is also tough because bike shops get buying discounts from the big three component manufacturers and are hesitant to take on new lines.

The third option, selling more stuff to existing customers, seems easier on the surface. After all, you already know who your customers are and they have self-selected as cycling enthusiasts with an affinity for new technology. You could probably sell them rims, cranks and shifters, but these products are not your specialty; you’d be lucky to match the quality of the big three on anything other than your brakes. In short, if you decide to sell more to your existing customers, you could succeed in growing your top line, but more revenue may do nothing for, and it may even hurt, the value of your company.

When growth shrinks value

Let’s imagine you decide to stick to brakes. If one of the big three component manufacturers offered to buy your business, and they paid the industry average multiple being paid for a niche company of 5.6 times earnings, they would pay $3,360,000 to buy your business with $600,000 in pre-tax profit (5.6 x $600,000 = $3,360,000).

Now, say you decide to chase top-line revenue growth by becoming a generic supplier of bike parts. You project that you could grow both your top and bottom lines by 20 percent. If you’re successful, you’ll have a business generating $720,000 in profit a year from now.

But you would get that growth by offering a similar version of the products the big three component manufacturers already sell. Therefore, acquirers would be unlikely to offer you the premium they would offer to a niche company. After all, the moment they buy you, they will jettison the parity products where they enjoy economies of scale, and then focus on leveraging your braking technology. You might be offered the growth company multiple of 4.3 times your $720,000 in profit, or $3,096,000. Even with significant growth, you would still be worse off than if you had stuck to your niche.

But keep in mind that chasing growth is costly, and typically comes at the expense of your margins. If your profit dipped to $400,000 to fund your 20 percent growth, your business might be worth 4.3 x $400,000 = $1,720,000–almost half that of the slow growth niche player.

Growth is intoxicating and may fuel your ego, but remember: it is the growth of your niche product or service that really increases the value of your company.