As it turns out, buyers are astute business valuation analysts. They look for certain features when they assess the desirability of a business acquisition. Private equity groups are particularly rigorous during this process. Many M&A advisors will receive at least five contacts per week from private equity groups describing their buying criteria. The most surprising statement contained in a majority of these solicitations is: "We are pretty much industry agnostic." Of course, they may add in a couple of qualifiers like, "We avoid information technology firms, start-ups and turn-arounds."
Typical Investment CriteriaHere is a fictitious example of a private equity investment criteria. Capital Group seeks to acquire established businesses that have stable, positive cash flows and EBITDA between $2 million and $7 million. We will consider investments that satisfy a majority of the following characteristics:
- Revenues between $10 million and $50 million
- EBITDA between $2 million and $7 million
- Operating margins greater than 15%
- Owners or senior management willing to transition out of daily operations
- Experienced second tier management team willing to remain with the company
- Long term growth potential
- Large and fragmented market
- Recurring revenue business model
- History of profitability and cash flow
- Medium to low technology
Every Buyer is Looking for Great CompaniesThe fact is that 5,000 other private equity firms are looking for the same thing. It is like saying, "I am looking for a college quarterback that looks like Peyton Manning." There's a pretty good chance that he will be successful in his transition to the pros. That is exactly what the buyer is looking for - a pretty good chance that this acquisition will be successful once purchased. Give just about any buyer a business that looks like the one above, and he or she will go running for it.
On the other hand, more often than not, we are representing seller clients that do not look nearly this good. Getting buyer feedback on why a client is not an attractive acquisition candidate is often a painful process, but can be quite instructive. Unfortunately it is usually too late to make the needed changes during the current M&A process. Many businesses are great lifestyle businesses for the owners, but they do not translate into an attractive acquisition for the potential buyer because the business model is not easily transferable and scalable.
In these businesses, the value the owner can extract is greater by just holding on and running it a few more years that he can realize in an outright sale. What are these characteristics that reduce the salability of a business or diminish its value in the eyes of a potential buyer?
Value DestroyersThough there are quite a few different ways to destroy value, there are often some things that form trends. Here are the top 5:
1. The business is too transactional in nature.
What this means is that too much of the company's revenues are dependent on new sales as opposed to long term contracts. Contractually recurring revenue is much more valuable than what might be called historically recurring revenue.
2. Too much of the business is concentrated within the owners.
Account relationships, intellectual property, supplier relationships and the business identity are all at fish when the business changes hands and the owners cash out and walk out the door.
3. Too much of the business is concentrated in too few customers.
Customer concentration poses a high risk for a new owner because the loss of one or two accounts could turn the buyer's investment sour in a big hurry. The buyer fears that all accounts are vulnerable with the change in ownership.
4. Little competitive differentiation.
Buyers are just not attracted to businesses with no identifiable competitive advantage. A commodity product or service is too difficult to defend and margins and profits will continually be challenged by the market.
5. The market segment is too narrow, has too little potential, or is shrinking.
If your market place is so narrow that even if your company had 100% market penetration and you sales were capped at $20 million, a larger company would not get very excited about an acquisition because you could not move their needle.
Benefits of Negative FeedbackA business owner that is contemplating the sale of his business could greatly benefit from this rigorous buyer feedback two of three years prior to actually beginning the business sale process. A valuable exercise to take business owners through is a simulated buyer review. During this process we help identify those areas that could detract from the business selling price or the amount of cash he receives at closing.
This process is certainly less painful than when we were negotiating a letter of intent with a buyer and he said to our client, "Sir, your overhead expenses are 20% too high for this sales level." Another buyer in another client negotiation said, "I can't pay you a lot in cash at closing when your assets walk out the door every night. It will have to be mostly future earn out payments."
As a business owner, one can both identify and fix a company's value detractors prior to sale or can let the new owner correct them and keep all that value himself. Viewing the business as a buyer would well in advance of the business sale and then correcting those weaknesses will result in a higher sales price and a greater percentage of the transaction value in cash at closing.