The impact of non-financial matters on the valuation of businesses

In this week’s article, Stephen Groves of Groves & Partners is our special guest providing some insights into valuation and the key non-financial considerations that are relevant to a valuation of a business.

In this week’s article, Stephen Groves of Groves & Partners is our special guest providing some insights into valuation and the key non-financial considerations that are relevant to a valuation of a business.

What are Business Valuations?

Business valuations are expert reports providing comprehensive yet concise guidance on the value of a business, clearly explaining the rationale and methods used in determining the business’ value.

What are business valuations used for?

Business valuations are designed to be user friendly and compiled with the end purpose firmly in mind. On this basis, business valuations compiled for use in the courts or by third parties such as creditors or the Australian Taxation Office may take a different format to those written for confidential use by business owners for the purpose of planning for the future.

What impacts a valuation?

Whilst the value of businesses is inherently tied to their financial performance, there are a number of key non-financial considerations that have common applicability to the value of businesses and often have a material impact on value.

Importantly, the same non-financial factors which impact valuations of businesses can cause significant business distress and can lead to solvency issues when such matters are in disarray.

What are the key non financial factors in a business valuation?

Herein we discuss key non-financial factors which in our experience have a significant impact on the value of businesses.

Those factors include:

  • Real Property Leases
  • Employee Matters
  • Customer and Client Considerations
  • Supplier Considerations
  • Personal Goodwill of Directors and Shareholders

Each factor has some key issues that impacts the valuation and is discussed in detail below.

Real Property Leases

Key takeaway

Key items that should be considered for real property leases as part of a business valuation include length of lease, restrictive covenant clauses and related parties. Length of the lease, relocation costs, demolition clauses and market rent when there is a related party are all examples that these key issues.

Business arrangements concerning leases for real property will generally have a major impact on the risk profile of a business.

Length of Lease

The timeframe remaining on a lease can have a major impact on the value of a business. If the remaining term on a real property lease is quite short a risk may exist to the future operation of the business beyond the remaining term of the lease. Further, the business may encounter costs should there be a requirement for the business to be relocated. Risks such as these often discount business values.

Restrictive Covenant Clauses

Consideration should be given to any restrictive covenant clauses contained within real property leases. One of the most common such clauses is a demolition clause, which generally allows a landlord to demand that a tenant vacates leased property under certain terms.

Clauses such as these should be assessed on a case-by-case basis, however they can present a major risk to businesses where they exist and accordingly, can mean that business values will be discounted.

Related Parties

Oftentimes, businesses will lease real property from a related party. An assessment should be made as to the commerciality of rent being paid by the business to the related party – If the rent is not in line with market norms, an adjustment will be required.

Employee Matters

Key takeaway

Key items that should be considered for employee matters include roles and responsibilities and risks of exit. Degree of cross training, unique roles by employees in the business, staff turnover, age of employee group and career opportunities are all examples that these key issues.

All business owners understand that good employees are vital to the success of their business. Quality employees take responsibility, build strong relationships with staff and suppliers and inspire other staff members to put in their best efforts at work.

Many business owners have also experienced the damage and havoc that can be caused by one or two rogue staff members.

Based on this, the quality and reliability of a business’ employees will have a direct impact on the value of a business.

Key considerations that should be made with relation to a business’ employees are outlined below.

Roles and responsibilities

What roles and responsibilities do individual employees have in the business? Further, what degree of cross training exists between different employees? This is especially important for employees who take on managerial responsibility or team leadership roles and for employees with unique and important relationships with customers or suppliers.

In circumstances where there are employees who play a unique role within a business with limited capabilities amongst other employees or in the broader job market to assume those responsibilities in an effective manner, a notable risk exists to the business’ future performance. Should the employee exit the business, key skills may be lost and customer or supplier relationships may be fractured. Accordingly, these risks will likely have a negative impact on the business’ value.

Risk of exit

What is the likelihood of employees exiting the business? Normally when assessing this it is important to consider:

  • Employee turnover data: That is, on average how long will an employee stay with the business, and what percentage of employees generally exit the business on an annual basis? These measures help in making an assessment of the chances of employees leaving in the near future, as well as the likely number of employees to do so. If employee turnover is quite high compared to similar businesses, there may be a negative impact on the enterprise’s value.
  • Age of employees: How many employees are approaching retirement age? What is known about individual employee’s plans for the future? If key employees are approaching retirement age, there may be a negative impact on the business’ value.
  • Promotion and career advancement opportunities: What opportunities can the business offer to skilled and talented team members? What is the chance that capable and experienced employees will leave the company to further advance their career? This is a difficult factor to measure, however careful analysis of key personnel is required in order to measure what risks may exist.

Customer and Client Considerations

Key takeaway

Key items that should be considered for customer and client considerations as part of a business valuation include spread of customers and contracts and relationships. Heavy reliance on small customer base for revenue, length of contract and exit penalties are all examples that impact these key issues.

A business’ customer or client base can impact on the value of the enterprise. Key considerations that should be made with relation to a business’ customer and client make-up are discussed in detail below.

Spread of Customers

Businesses that have a few major customers that make up a large portion of their annual revenue can be rather risky. It’s useful to assess each major customer on a case-by case basis, and give consideration to the nature of the business’ industry when assessing the impact of such risks.

Contracts and Relationships

Customer contracts should be assessed based on their materiality, the term remaining, and the strength of exit penalties. Often, long-term customers will not be retained on a contract basis – they simply remain with the business owing to a strong relationship.

Where customers remain with a business on a relationship basis only (that is, no formal contract in place), an examination of the nature of the relationship should be made. Is the relationship with the owner of the business? Could a salesperson in the business take the relationship with them to a competing firm? These relationships should be assessed on a case-by-case basis.

Supplier Considerations

Key takeaway

Key items that should be considered for supplier considerations as part of a business valuation include freedom to choose my a multitude of suppliers and difficulty of sourcing supply.

The strength or weakness of a business’ supplier base will greatly impact on the business’ value.

Does the business have the freedom to choose from a multitude of similar suppliers with similar products or services, or are they tied to one or two key suppliers?

When a business is tied to one or two key suppliers, with limited opportunity to source goods or services elsewhere an assessment of those supplier’s stability, in conjunction with an assessment of risks contained within supply agreements is needed in order to determine the impact on the business’ value.

Personal Goodwill of Directors and Shareholders

Key takeaway

Key items that should be considered for personal goodwill of directors and shareholders include how integral they are to the business and is there a strong management structure in place.

How integral are the Directors and Shareholders of a business to that business’ success?

‘Owner-operator’ businesses where one or two working proprietors hold a significant amount of non-transferrable knowledge are generally difficult to sell in the marketplace, meaning their values are normally discounted.

On the other hand, businesses with a strong management structure in place, and proven systems and procedures are often easier to transact in the marketplace and generally attract a premium among business buyers demonstrating a positive impact to business values.

Conclusion

Business valuations are heavily impacted by non-financial factors. Such non-financial factors, when in disarray, can cause significant distress to businesses and a significant portion of businesses fail because of poor management. It is imperative that business valuations appropriately consider and respond to non-financial matters such as those discussed in this article to appropriately determine business valuations that reflect the commercial realities of the subject business.

About Groves & Partners

Groves & Partners partner with businesses and their advisors to provide expert advice on business sales, business acquisitions, due diligence, valuations and analysis. The team of experts negotiate business sales and acquisitions that provide outstanding commercial outcomes, assist with complex financial analysis, business valuation and due diligence matters, and provide reliable, forward-thinking strategic advice. From offices in Sydney and Brisbane, Groves & Partners work with businesses across Australia and the Asia Pacific.

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