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Key Value Drivers: How To Assess It & How To Fix It
By Dave Stein, CEO, The Stein Advantage, Inc., and Henry Bonner, Principal, Fairlead Capital Management, LLC
A Question of Risk
While there are many Key Value Drivers in every business, for the moment, letís ignore the value contribution of Intellectual Property, other assets and, of course, goodwill. Instead, we will look at the value contribution of the revenue forecast. Given your inability to guarantee the pro-forma cash flows (in the way a U.S. Treasury Bill might), there must then be an adjustment for risk. This is where it can get interesting. Risk in this case, is the uncertainty around exactly what will the future cash flows be. The risk adjustment will naturally reduce those cash flows you forecast, which in turn reduces the valuation. So by argument, a more credible forecast is less risky and therefore more valuable.
Consider your own business. You may have pro-forma income statements for the next few years. The top line revenue numbers are based on your view of the market; perhaps some expectation of a new product or version being released which you could upgrade your customers to; maybe there is an external event, such as a new regulation, which would require your market to implement a system such as yours. Regardless of this, your pro-forma is just an estimate, a form of your expectation. If you feed the resulting pro-forma income statement into a valuation model, a risk adjustment, which may be subjective, will be based on the degree to which your forecast is convincing.
Forecasting (Part 1)
So, letís look at the forecast. Assuming you are a software business and consulting revenues are a function of your license sales, the revenue forecast is largely driven by new licenses and recurring revenues. How well is your forecast supported by your current sales pipeline? Letís say that your typical sales cycle is 3 to 6 months. Given your historical win rate (which, of course, you have recorded for just such an analysis!), you can now easily demonstrate that your current sales pipeline, adjusted for probability of deals closing, supports your forecast for the next period. Or can you?
More often than not, small, fast moving, entrepreneurial businesses do not make the time to manage a great level of detail in the sales pipeline. Perhaps you maintain call lists, lead sheets, and once a prospect becomes real, you have a Ďfeelí for where you are with each proposal. All well and good, until you try to convince a third party where you think the numbers are going to come from.
Think of your sales pipeline not only as a tool for sales management, but as a demonstration of your ability to accurately forecast your future revenues. Your sales pipeline is a Key Value Driver.
If you follow this premise, and you are interested in increasing the valuation of your company for acquisition or a capital infusion, there is a lot of leverage in the product of quantity (demand) times the quality (credibility) of that sales pipeline.
Letís Take a Look at Pipeline Quantity
What demand creation and demand servicing processes does your company have in place to feed the pipeline? And what metrics are being employed to continually refine those processes so that more leads are coming in, and if your market and products will support it, leads with higher revenue potential?
To start, we believe that depending on a single source of leads is not a good idea. In the software industry, some lead generation programs work for a while and then become ineffective. Companies who maintain an adequate pipeline to support their sales targets know that adjusting the balance in various lead generation initiatives is the answer. Your marketing director should have a comprehensive, flexible plan going out at least six months showing how trade shows, print ads, banner ads, e-mail campaigns, web seminars, live seminars, direct mail, telemarketing, media relations, and analyst relations will all be used, measured, and adjusted if necessary. And you need to fund those efforts. Hold on, you say. Weíre small and donít have a marketing person. Thatís a challenge, which every small company must overcome. If you are serious about increasing your companyís valuation, youíll need to make an investmentóeither in a part-time employee or in outsourcing this function to an expert. The message here is that you must have a proven and effective process for finding or creating sales opportunities.