It has been often said that you can’t manage what you don’t measure. Far too often, small to medium sized business managers fail to objectively measure the long term impact of their major capital expenditures. 

​Normally, a ton of work is done up front, by choosing the right equipment, design, vendors etc., with a clear focus on the future benefits for the company.  However, often too little work is done on return expectations under best case/worst case scenarios, let alone ensuring on-going evaluation and assessment once the project is completed. 
 
The cumulative impact of your capex decisions can have a major effect on your long term profitability and perhaps even more importantly, the value of your business.  It goes without saying, that if you make a series of good capital project decisions that result in shorter than expected paybacks or higher ROI’s, it can have a very positive effect on the business value and profits. Conversely, by making a series of marginal or poor capex decisions, it can really devalue a business over the long term.

For many established businesses, a quick way to evaluate the cumulative impact of your capital expenditure decisions is to look at your historical depreciation plus capital lease expense in relation to your operating profit.  If the former has been growing faster than the later, then you are likely not setting the bar high enough on your decisions to spend capital, unless you are consciously and aggressively growing market share or investing in new business areas that are expected to have a long term positive impact.  Of course, there are ways to accelerate depreciation, based on allowable tax rates for example, that can really skew this metric and it is therefore most applicable when you use depreciation rates that match the useful life of the purchased asset.

One of the areas that managers need to consider, when making capex decisions, is their weighted average cost of capital (WACC – ask your accountant to calculate/estimate your WACC - every private business owner needs to know this number).  In order to build long-term enterprise value, the return on capital expenditures should always be higher than your WACC, even under your worst-case scenarios.  This is especially critical for expansionary projects.  It needs to be the minimum hurdle rate you use to assess the viability of every new project.

Companies with little or no debt can destroy business value by investing in projects that provide returns that are insufficient to cover their cost of capital, even if they actually contribute to the business earnings.  Obviously for companies with high levels of debt, the project could have severe repercussions should it not generate the expected cash flow.  Even so, the prudent use of debt financing can often lower your WACC, especially for established companies with a solid asset base and a positive cash flow track record. Therefore, debt financing should be considered, as it can widen the spread between the project’s return and your WACC, which builds enterprise value.

Finally, don’t forget to assess the impact of the project will have on working capital.  Like your fixed capital, there is a cost associated with working capital, regardless of its source, and therefore you need to get a return over and above its cost.  Capital projects that increase efficiency can decrease working capital as well as lower other operating costs. However, projects that are undertaken to facilitate topline growth can result in increases in inventory or receivables for example.  All positive and negative impacts to working capital need to part of the evaluation process.

Knowing your business’s track record on each major project helps your fine tune your evaluation process, and thereby provide the basis for continuous improvement.  An accurate, objective and analytical assessment of the project’s ROI needs to be imbedded into your capital decision making process, if the goal is to build real and sustained value into your business.

We all know that the actions you take today will influence business performance in the future, and therefore its marketability and value, should you decide to sell.  Many of those actions can directly influence the “quality” of the business’s future revenue.

High quality revenue is generally considered to be sales that are sustainable and predicable, are profitable and come from a diversity of products, customers, markets etc.  High quality revenue reduces risk for any new owner or management team and therefore can increase business value.
 
For a sale or recapitalization with a financial buyer, such as a Private Equity firm, family office, and private investor, the quality of the revenue is a critical determinant of value, and indeed an important pre-qualifier for many.  Many will have their own criteria on how they assess revenue quality.  Suffice it to say, that acquisition candidates with narrow product lines, and/or in singular markets with high customer concentration are often a “pass”, even if the business is very profitable.  Other financial buyers that are less risk averse or use less leverage to finance their transactions, may be interested, but only when growth prospects are very strong and/or when they can buy “cheap.”

For insider or family transfers, high quality revenue improves the probability that next generation management will have the cash flow to pay off a seller note, pay down any outside loans used to purchase the business or to redeem legacy owners preferred shares.

It may be a different story if you are looking for an eventual sale to another industry participant, or a “strategic” buyer, including those that are Private Equity sponsored (i.e. those looking for “add-ons” for a portfolio company they own).  Revenue that comes from a wide diversity of customers, markets or products may, or may not be an important criteria, and therefore may or may not be reflected in the value of an offer.

Strategic buyers may be interested in your business only because it adds something specific (E.g. a product line, management talent, your facility) to their business that will take too long or would be too difficult or expensive to build/develop organically.  If that valued attribute, such as a product line, makes up only a portion of your overall business, the rest of it may be discounted.

Consolidation strategies can create cost saving and revenue synergies for a buyer, but it is difficult for them to justify paying for redundant products/product lines that could be discontinued post-acquisition.  Forward, backward and horizontal integration strategies all impact the perspective a strategic buyer will have on the value of your business and the importance of your revenue quality.

On the other hand, if the strategic buyer is looking to buy your business and run as a separate business unit, then your revenue quality is very important.

It therefore pays to know what the key strategic acquirers in your industry are looking for.  You can discover a lot by watching and learning from the actions they take in the marketplace.  Are they buying companies for their technology, access to new markets, to diversify their product lines, for their customer base etc.?  It may be best to begin to build a relationship with them to better understand their acquisition strategies, but they may be reluctant to share much if you are a competitor or not immediately open to a sale.

You can also build relationships with investment bankers/M&A Professionals focused on your industry. i.e. those that have regular discussions with senior leadership at strategics and understand the types of acquisitions they are pursuing.

It is a mistake to assume that a strategic will always value your business higher than a financial buyer, unless you build your business and its revenue base around what would make it the perfect strategic fit.

A lot of entrepreneurs with no immediate plans to sell, simply hope that one day a big industry executive will just drop off a huge cheque. They are usually disappointed. Others hope to transfer to insiders like family or management, but don’t decisively work towards building high quality revenue streams to ensure the business can be paid for.  If a sale to Private Equity is an option you are considering, the actions you take today to improve your revenue quality should pay off by generating interest by a larger pool of financial buyers willing to compete for the opportunity to invest in your business.
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The key is to know the exit path you want to take well in advance of your planned exit and to think strategically about the quality of revenue.  The sooner you decide your optimal path, the better you will be able to shape the business’s revenue quality to ensure that path is viable.