I have a secret to tell. It’s something I haven’t shared with many people, but now it feels appropriate to do so.
Most people know of me as just this random M&A advisor who writes a few blog posts on buying and selling businesses, but there’s a little more going on behind the scenes.
I recently confirmed something about myself that I had suspected for a long time: I have the ability to read minds. (Disclaimer: this is only in the context of a buyer considering the purchase of a business. Unfortunately, it doesn’t work so well with my wife). This power is particularly strong when it comes to prospective buyers determining the valuation of a business.
Generally Accepted Valuation Approaches
Any professional business valuator will tell you that there are three primary valuation methods:
- The Income-based Approach — quantifies the net present value of future cash flows associated with ownership of the equity interest or asset.
- The Market Approach — determines fair market value by reviewing actual valuation metrics on comparable companies and transactions.
- The Asset-based Approach — uses the current value of a company’s tangible net assets as the key determinant of fair market value.
As a Chartered Business Valuator, I am well-versed in the application of these methods and have professed their worthiness as valid approaches over my career. But my ESP told me that business buyers just didn’t give a damn about the valuation reports that I was preparing for my sell-side clients. Also, mental telepathy tells me that different buyer types place different values on prospective targets, so a one-size-fits-all approach is not appropriate for business valuations.
If you don’t believe me, try this out. Before selling your business, hire a business valuator to prepare an expensive valuation report. Give that report to a prospective buyer and tell them to pay that price noted within. Nine out of 10 times, the buyer throws the report in the garbage and provides you a different offer that they think is fair. My advice is not to waste your money on a valuation report, but rather to find an experienced M&A advisor to provide you with their thoughts on who is a likely buyer and what price they can get in the market. If the minimum price meets your expectations then move ahead and trust that your advisor will do their best to get more.
Business Buyer Valuation Method (the Only Method that Matters)
With my mind reading talents, I feel it is my obligation to tell entrepreneurs how buyers actually value a business. Here it is. The price that a business buyer will pay is dependent on three factors:
- who is the buyer;
- how the specific buyer will structure the payment terms of the negotiated purchase price; and
- does the check that the buyer has to write provide an adequate return on equity.
Candidly, when selling a business, determining these three factors is the only business valuation method that really matters. Here are steps to estimate the purchase price from different prospective acquirers using the business buyer valuation method:
- Determine who the most likely buyer is for your business;
- Prepare an achievable cash flow forecast that the prospective buyer will be able to realize (only consider growth and synergies if the buyer will be able to realize them);
- Determine how the specific buyer will structure the transaction (i.e. all cash, partial cash with financing, vendor financing, earnouts, etc.); and
- Based on the cash flows of the business and the buyer’s equity check, determine a valuation range that meets the buyer’s required return on equity.
I know you’re probably thinking, “How the hell am I suppose to know the answers to each step in the business buyer valuation method above?” Don’t worry, I am here to provide you with a guide using my mentalist abilities. Let’s take a look at each buyer:
Multinational Corporate Acquirer
Most multinational corporations can pay all cash for a mid-market transaction if they chose to. They also have the lowest cost of equity hurdles to overcome given their ability to quickly expand the acquired company’s market through their own distribution channels. Based on both of these factors, multinational acquirers will pay a higher purchase price than other prospective buyers.
Forecast: prepare projections that have aggressive (but reasonable) growth numbers, based on your knowledge of the buyer. Now cut your projections in half, because I know you have still been too aggressive (I’m a mind reader, remember?) Also, don’t forget to incorporate the costs that would be required to meet the growth targets (i.e. do you need to build corporate infrastructure to reach your target?).
Deal Structure: all cash
Return on equity: 15%–20%
Mid-sized Strategic Acquirer
A mid-sized strategic acquirer might be able to find some synergies, but not to the extent of multinational acquirers. It is also most likely that a mid-sized strategic acquirer will require financing to complete the acquisition. So, the purchase price will be limited by the acquired company’s ability to service debt obligations while remaining in line with all bank covenants.
Forecast: prepare projections that you would prepare for your business as if you will continue to run it, but consider all the cost synergies that a strategic buyer will enjoy from combining the two businesses.
Deal Structure: this buyer will obtain a conservative level of bank financing available from secured and cash flow lenders while making sure to maintain all debt covenants. The deal will also include vendor financing or earnouts depending on how much growth is baked into the forecasts.
Return on equity: 20%–30%
Private Equity, Family Office and Private Investors
Financial buyers are primarily concerned with achieving returns for their investors. They bring financial engineering expertise and look for experienced management to lead the operational charge. The abundance of cheap capital has allowed these buyers to compete with strategic acquirers on valuation levels.
Forecast: Similar to the forecasts prepared for mid-sized strategic acquirers, prepare achievable projections for your business — but don’t consider any cost synergies. A financial buyer will try to aggressively grow your business through acquisitions and other means, but they will not be willing to pay you for any of the future growth realized through initiatives that they execute.
Deal Structure: these buyers will obtain aggressive levels of bank financing available from secured and cash flow lenders. The deal will also include seller financing or earnouts because this will increase the financial buyer’s return on equity. In the deal structure, consider the maximum amount of seller financing and earnout that you are willing to accept, because financial buyers are going to push for the highest level that they can negotiate.
Return on equity: 25%–35%
Develop Your Valuation Mind Reading Skills
My sixth sense regarding business valuation is not something I was born with. I developed these skills over time and numerous interactions with prospective buyers. As business owners, as opposed to business valuators, I don’t expect you to reach my level of clairvoyance. Just follow the formula that I have presented and you will be able to read the mind of any prospective business buyer that you encounter.