Letting the Market Bridge the Valuation Gap
Using fair market value to help business owners bridge the gap between the valuation they feel they deserve and that which they're likely to receive increases the likelihood of a transaction.
Statistics show that a surprisingly low percentage of businesses for sale actually sell on the first attempt. The major reason for the lack of sales is the valuation gap between the buyers and the seller. This article discusses how that gap can be breached, resulting in completed business sale transactions.
In a survey that we conducted with business brokers and merger and acquisition professionals, 68.9% of respondents felt that their top challenge was dealing with their seller client's valuation expectations. This is the number one reason that, as one national investment banking firm estimates, only 10% of businesses that are for sale will actually close within three years of going to market. That is a 90% failure rate!
Setting Value Expectations for Business Owners
As we look to improve the performance of our practice, we looked for ways to judge the valuation expectations and reasonableness of our potential client. An M&A firm that fails to complete the sale of a client, even if they charged an up-front or monthly fee, suffers a financial loss along with their client. Those fees are not enough to cover the amount of work devoted to these projects. We determined that having clients with reasonable value expectations was a key success factor.
To give our clients an idea of the kind of offers they would receive for their business as-is, we prepared a mock letter of intent for them after analyzing their business. This mock LOI included not only transaction value, but also the amount of cash at closing, earnouts, seller notes and other factors we felt would be components of a real market offer.
If you can believe it, that mock LOI was generally not well received! Clients couldn't believe the value they gave their company wasn't reflected in our analysis. For example, one client was a service business and had no recurring revenue contracts in place — in other words, their next year's revenues had to be sold and delivered next year. Their assets were their people, and their people walked out the door every night. Our mock LOI included a deal structure that proposed 70% of transaction value would be based on a percentage of the next four years of revenue performance as an earnout payment. Our client was adamant that this structure would be a non-starter. Fast forward nine months and 30 buyers that had signed confidentiality agreements and reviewed the confidential information memorandum withdrew from the buying process. It was only after that level of market feedback was the client was willing to consider the message of the market.
We decided to eliminate this approach because it put us sideways with our client early in the M&A process. The clients viewed our attempted dose of reality as not being on their side. No one likes to hear that you have an ugly baby. We found the reaction from our clients almost that pronounced.
We tried probing into our clients' rationale for their valuation expectations and we would hear such comments as, "This is how much we need in order to retire and maintain our lifestyle," or "I heard that Acme Consulting sold for 1x revenues" or "We invested $3 million in developing this product, so we should get at least $4.5 million."
Unfortunately, the market doesn't care what you need to retire. It doesn't care how much you invested in the product. The market does care about valuation multiples, but timing, company characteristics and circumstances are all unique and different. We often hear examples like "IBM bought XYZ Software Company for 2X revenues so we should get 2X revenues." However, it is simply not appropriate to draw a conclusion about your value when compared to an IB-acquired company. You have revenues of $6 million; they had $300 million in revenue, were in business for 28 years, had 2,000 installed customers, were cash flowing $85 million annually and are a recognized brand name. Larger companies carry a valuation premium compared to smaller companies.
The Price and Terms of a Sale Are Based On Several Key Business Characteristics
1. Contractually Recurring Revenue — by far the most powerful factor for driving favorable price and terms. You just need to look at Microsoft's stock price since the new CEO changed their business model from a one-time software license sale to a subscription model. Revenues went down short-term, but over the longer term, revenues have accelerated and the stock price has responded beautifully.
This characteristic is why all of the major software firms are converting to the SaaS (Software as a Service) Model.
For a business buyer, this significantly de-risks the transaction. The longer the contracts, the better. It is predictable revenue and the risk of large customer defections post-acquisition is greatly reduced. This is much more highly valued than a business that is driven by having to sell new business as the bulk of their revenue. So, the greater the percentage of revenue that is contractually recurring revenue, the higher the selling price for your business. The greater the contractually recurring revenue, the greater percentage of transaction value that will be payable in cash at closing. The lower the contractually recurring revenue, the greater the transaction value that will be shifted to a seller earnout, seller financing or both.
Also, the greater the percentage of contractually recurring revenue, generally the term of owner involvement in the business will be reduced. So if you have very little recurring revenue and you want to exit shortly after sale, good luck. The new owners will want you around to help transition the business and the customers.
2. Durable Competitive Advantage — There is a reason Warren Buffett is such a successful investor. He looks for businesses that have a competitive moat around them and that are not commodities. They have pricing power. This is a powerful driver of selling price and a meaningful factor in risk reduction.
3. Growth Rate — This is an area where the current EBITDA valuation model falls short. A firm growing revenue at 30% per year should be valued far higher than another firm with the same EBITDA growing at only 10% per year. Wall Street has accounted for this with their price/earnings/growth multiple. Growth rate is valued by business buyers, but they will try to use the EBITDA model to justify their price if you let them.
4. Customer Concentration — This is a value killer and a terms killer. If you have 40% of your business with one client and that client goes away, you do not have a business. That is exactly how a buyer looks at it and it normally scares them away. But if there is a transaction, it will be characterized with a very large percentage of the deal as an earnout and a much smaller percentage in cash at closing. The buyer will want the owner be involved for a long period of time to ensure these necessary customers stay.
The Valuation Challenge of Intellectual Property and Software Businesses
This issue becomes even more difficult when the business is heavily based on intellectual property, such as a software or information technology firm. These companies face a much broader interpretation by the market than more traditional brick-and-mortar firms. With asset-based businesses we can present comparables that provide us and our clients a range of possibilities. If a business is to sell outside of the usual parameters, there must be some compelling value creator like a coveted customer list, proprietary intellectual property, unusual profitability, rapid growth, significant barriers to entry or something that is not easily duplicated.
For an information technology, computer technology or healthcare company, comparables are helpful and are appropriate for gift and estate valuations, key man insurance and for a starting point for a company sale. However, because the market often values these kinds of companies very generously in a competitive bid process, we recommend just that when trying to determine value in a company sale. The value is significantly impacted by the professional M&A process. In these companies where there can be broad interpretation of value by the market, it is essential to conduct the right process to unlock all of the value.
Letting the Market Decide Value
How do we handle value expectations in these technology based company situations? M&A professionals are not the right authority on our client’s value, the market is. If the client feels like his broker or investment banker is just trying to get him to accept the first deal so that the representative can earn his success fee, there will be no trust and probably no deal.
If the client sees his representatives bring multiple qualified buyers to the table, present the opportunity intelligently and strategically, fight for value creation, and provide buyer feedback, that process creates credibility and trust. The client may not be totally satisfied with the value the market is communicating, but he or she can see the reality of the situation. The likelihood of a completed transaction increases dramatically after this.
The client is now faced with a very difficult decision and a test of reasonableness. Can he or she interpret the market feedback, balance that against the potential disappointment resulting from his or her preconceived value expectations and complete a transaction?