Picture this scenario: On the same day, the owners of two companies complete transactions to sell their respective companies to two separate buyers.
The two companies being sold are nearly identical. They have similar products and services, serve similar markets and have similar revenues and profitability. Yet one sells for $ 11 million while the other sells for $17.5 million. Why such a difference?
Despite surface similarities, there are probably hundreds of factors that make these two companies more or less attractive as acquisition candidates, thereby increasing or reducing their respective values to a buyer. Understanding these differences is critical to any seller, and it is the main reason why owners of small and midsize businesses (who are rarely experts in mergers and acquisitions) seek professional representation when selling their companies.
Merger and acquisitions valuations have changed significantly over the last few years. Just a few years ago, public companies were being handsomely rewarded in the financial markets just for making acquisitions. Consequently, many were grabbing up every perceived synergistic deal they could find, almost without regard to the price. However, buyers are now examining the values of potential acquisitions much more cautiously – conducting greater due diligence and exhibiting more skepticism toward the seller’s projected performance.
We still see premium valuations in the marketplace, but these values are typically being obtained by sellers who are well prepared to run a thorough and efficient selling process. Following are some basic guideposts to follow on the road toward a successful and lucrative business sale. The first step business owners must take is to assess and understand their company’s market value. Many business owners do not want to dedicate the time or money necessary to learn their company’s true value in the market. Some believe it is too difficult, or they don’t have the right skills or resources; others think they already have a pretty good idea of what it is worth (and they’re usually wrong). Knowing the company’s value in advance puts the seller at an advantage. Determining the market value for a privately held business is as much art as science, but a professional, experienced valuation team can provide a valuation that instills confidence in the seller when approaching and negotiating with prospective buyers.
Every business is unique, and there is no single, simple formula for determining market value. Rather, it is the culmination of a thoughtful, time consuming process that requires extensive market research and financial analysis to reveal the company’s future potential under new ownership. The process usually begins with recasting the business’s historical financial statements, typically the balance sheet, income statement and statement of cash flows. As part of this recasting, certain expenses and extraordinary items legally used by private, owner-managed companies to define tax benefits are eliminated, and other adjustments are made to conform to generally accepted accounting principles. These adjusted financial statements offer potential buyers a normalized view of the company’s past performance.
It is important to remember, however, that buyers buy the future, not the past. Therefore, while essential, these adjusted historical financials alone do not determine a seller’s optimum value to a new owner. Rather, they serve as a starting point for building “pro forma” financials, which look five years into the future and are the basis of market value. “Pro forma” financials require extensive market research to determine reasonable, supportable assumptions regarding revenue and profitability trends, growth rates, market dynamics and other factors.
Also integral to the valuation process is the identification and examination of intangible assets. These factors may be important contributors to the company, but aren’t necessarily represented in the financial statements. These include a loyal customer base, patents and licenses, supplier contracts, trade secrets, distributorships and many others. All of these elements – adjusted historical financials, intangibles and reasonable pro forma financials – come together to reveal the company’s future potential and establish a valuation range that informed buyers will likely be willing to pay for the company.
Many sellers assume that their most likely buyers are close by – local competitors or a major customer, for example. In fact, these types of candidates may be less attractive buyers because their purchase decisions are typically driven by a desire to acquire assets, consolidate redundant functions and cut costs. Wise sellers look beyond just these candidates to seek out the largest possible pool of strategic buyers who may be willing to pay a premium to acquire the future potential and intangibles of the company – not just its tangible assets. These strategic buyers can include larger private and public corporations, both in the U.S. and abroad.
Market conditions currently make acquisitions of mid-size private companies especially appealing to large strategic buyers. Wary of the risks associated with large, high-profile deals, many corporations are seeking smaller acquisitions of private companies that help to expand product lines and distribution channels, reach new customers and markets, and leverage existing technology and R&D capabilities. Buyers look to reduce the amount they will pay for a business and will attempt to do that by ignoring the seller’s strengths and focusing on the company’s weaknesses.
Buyers go through significant due diligence to try to uncover as many weaknesses as possible to use in negotiations. Sellers are fooling themselves if they think a buyer won’t uncover their “dirty laundry” in the due diligence process. Nothing reduces valuations or destroys deals more quickly than “surprises” during the due diligence process. Hidden liabilities, conflicting data and vague information will cause a potential buyer to, at best, reduce the offering price and, at worst, withdraw from the process. Prepared sellers have explanations to mitigate the buyer’s potential issues or concerns and emphasize the company’s strengths. When sellers know the potential issues in advance, they can prepare appropriately and take them out of the value equation.
Remember, a buyer is buying the seller’s future. Anything that raises red flags, or in any way causes concerns about the seller’s business or management’s knowledge and ethics, will detract from value and could kill the deal. The greater the buyer’s confidence in the seller’s story and answers, the more likely they are to offer a premium or at least fully value a company.
Having the company’s growth story down enables the seller to present it confidently and consistently each time and goes a long way in building potential buyers’ confidence. The idea is to highlight operating statistics or market research that supports and helps to tell the seller’s story. Without that support or a consistent growth story, the valuation suffers.
A merger or acquisition can take two years to complete. There is a lot of time for the buyer to determine the reliability of a seller’s projections. “Pro forma” statements are generally provided at the beginning of the process. Missing those projections or restating the pro forma statements could cause the buyer to lose confidence in management’s projections. There are a number of reasons why a company’s performance may be worse than projected, and some are easier to explain than others.
One of the most avoidable is management’s loss of focus. I’ve often seen a company’s performance deteriorate as management focuses on the sale rather than running the business. Sellers get so involved with answering questions and running the sale process that they don’t have time to care for the very thing they are trying to sell. Missing projections will cause the buyer to price in an “uncertainty” discount, as they will question the accuracy of future cash flows. The question arises: If the seller can’t even accurately project the first few months or even one year out, how can they project two or three years out?
Due diligence is a critical and sensitive period in the sale process and an area where the novice seller is often in a weak position. At this point, the buyer pool has been narrowed to just a few of the most serious prospective buyers. As such, buyers have considerable leverage. But sellers don’t have to be powerless; this is actually an opportunity for the seller to maximize the company’s value. By actively managing the process, providing potential buyers with quality information and moving with deliberate speed, sellers gain more control.
By being prepared, anticipating the buyer’s questions and closing the deal quickly, the seller disarms the buyer and reduces the buyer’s bargaining power. Studies have shown that the longer the due diligence process lasts, the more likely the initial offering price will be reduced. A streamlined, professional process decreases the amount of time owners and managers, as well as buyers, must dedicate to the process.
Maximizing the sale price of one’s business is clearly a daunting challenge, and one that requires experienced professional advice. Beyond the core value drivers of the business, adequately preparing for the marketing process upfront, identifying the largest possible pool of domestic and international buyers, meeting financial and operating projections and effectively managing the due diligence process to reduce the overall timeline involved will positively impact valuation. By doing their homework, it is possible for sellers to achieve a much higher value for their company, regardless of market conditions.