Mind the Gap: Using Valuation for Gap Analysis
Our clients use business valuations for all sorts of reasons. Litigation? Check. Underwriting? Yep. Shareholder Agreements? Absolutely. But one of the ways we love to see our clients engage our services (and quite frankly we don’t see this reason enough) is for gap analysis.
What Is Gap Analysis
It sounds fancy, right? As a concept, gap analysis is pretty straight forward. From the Business Dictionary:
A technique that businesses use to determine what steps need to be taken in order to move from its current state to its desired, future state. Also called need-gap analysis, needs analysis, and needs assessment.
Gap analysis consists of:
- Listing of characteristic factors (such as attributes, competencies, performance levels) of the present situation (“what is”),
- Listing factors needed to achieve future objectives (“what should be”), and then
- Highlighting the gaps that exist and need to be filled.
Gap analysis forces a company to reflect on who it is and ask who they want to be in the future.
Using a Business Valuation for Gap Analysis
As with many things you can think of valuation in terms of a bell curve. For any given company there are a range of potential valuations. Certain scenarios will present on the lower end of the curve. A perfectly average company presents in the middle. And of course extraordinary companies present at the top end of the value range.
By engaging a firm to perform a business valuation, you are essentially laying the ground work for establishing the “zero case,” or Vo in our illustration. The question, then, is how do you move the valuation to reach a higher valuation? Your valuation analyst can work with you to understand:
- What factors or risk present in the company that are holding value down?
- What actions might the company take to improve value?
- Are their risk mitigation steps that the company might take to improve value?
- What will the impact on improved earnings have on value?
Ultimately, we are going to end up with a chart that looks like the below.
Improved Earnings and Reduced Risk: The Double Whammy
One final note. Working through a gap analysis (which ultimately is often a several year process) often has the impact of focusing management on risk areas to address and profit potential to improve on. When you undertake steps to improve profit AND mitigate risk, you are essentially improving your valuation “multiple” AND multiplier. Your return is more than 1:1.
Your initial valuation indicated a V0 of $5m. Your valuation multiple (we hate these but they work for illustration) is 4.0x. So $1.25m earnings times 4.0x multiple = $5m valuation. After working through your gap analysis and implementing a plan to improve, you’ve mitigated most of your serious risk factors. Earnings have improved to $2.0m. Your valuation multiple has improved to 5.0x. New valuation? $10m. Woot.