We are always surprised by how many business owners sell their business to a pre-emptive buyer without talking to an M&A advisor, or any other buyers for that matter.
This may sound self-serving coming from an M&A firm, but you only sell your business once so it makes sense that you should seek the advice of experts in that field—a team who can ensure that the business is properly prepared to sell, that the transaction goes smoothly and help you achieve the highest price with reasonable terms.
Talk to an Advisor
There are a number of reputable M&A advisors who specialize in mid-market transactions; who can help owners position a business to sell, provide feedback on value, manage the sale process, find the ideal buyer, and negotiate the terms of sale.
Find a firm that has experience, a proven track record and with whom you can have a productive relationship. It can take a while to close a deal so you need to be able to trust and respect them.
Even if you are inclined to go down the garden-path with a pre-emptive buyer that has knocked on your door, having an M&A advisor on your side of the table has distinct advantages over going-it-alone.
Be honest about your skills, and time available to manage the process yourself. A career spent building a business as an entrepreneur may not adequately prepare you to deal directly with a sophisticated buyer, especially when the topic up for debate, is a business you’ve invested a significant portion of your life building.
In short, deal fatigue is real but, can be mitigated if you have the right resources at your disposal so you can focus on running your business while the M&A team focuses on your deal.
Furthermore, having an advisor involved generates competitive tension. Period!
Even if you already have a specific buyer in mind or are already in discussions with them, an M&A advisor at the table, implies that you are seriously considering a potential sale.
It communicates to the buyer that if they don’t come to the table with a serious proposal, then you will go talk to the broader market, including their competitors. They won’t want that to happen so they will be inclined to put their best foot forward, so to speak.
Selling a business takes time. It can take up to one year to prepare the business prior to hitting the market, another six months to a year to close a transaction, and another one to two years to fully exit from managing the business. Therefore, if you your goal is to be on the beach in three years, the best time to start discussions with an advisor is right now.
Furthermore, if you read the FAQ, How can I maximize value in the sale of my business, you will know that some of those value-drivers will take time to implement into your day-to-day business processes, tax strategies initiated, and divesting non-core assets; as just a few examples.
There are a number of internal and external factors that influence a buyer’s valuation for your business. Some factors you can influence—others you can’t.
However, you can control how you run your business and how you exit and these two elements have the most direct influence on value.
When you sell your company the key to maximizing the sale price is to first understand your company’s unique value proposition and second, to convey that information to the right buyers. It is critical to identify and communicate to buyers the value drivers most relevant for your business and current circumstances.
Obviously, measurable data such as financial performance, contribution margins, and scale of the business are important considerations for any buyer, but ultimately it boils down to the buyer’s perception of risk inherent to your business.
High performing businesses enjoy robust valuations even in tough economic times, because their financial performance is more “shock” proof. This resilience is often driven by qualitative factors directly resulting from management decisions.
These “qualitative” factors such as a strong management team, reputation in the market, concentration risk and barriers to entry, influence a buyer’s decision to pay up or down in the possible value range for your business.
We could literally write a book on this topic. In the interim, we have a presentation that we would be happy to walk you through. Below are a few highlights.
An important benchmark used by buyers to evaluate a business is a company’s financial track record and how transparent, or easily understood, it is.
Your company’s finances need to be presented in a clear and concise manner, with any normalizing adjustments accurately represented, while highlighting positive trends and forecasts so the buyer understands the true potential of your business.
Successful businesses typically have loyal customers resulting in recurring revenues or long-term contracts. Such customer loyalty can stem from competitive pricing but it is more often due to quality of service, reliable people, reputation, innovation or some other differentiating factor. Whatever the reason, it is important to make sure the buyer knows why you have a loyal following.
While it is preferable to allow appropriate time to transition the business to a new owner sometimes there are circumstances which prevent a timely handoff.
Regardless of the situation, it is important to get aligned on this topic early in the process. Where possible, having a management team in place to reduce the risk associated with a founder’s exit provides stability to the business and is a key contributor to value.
Barriers to Entry
Prospective buyers are constantly evaluating “buy” versus “build” decisions. The most attractive companies to “buy” offer barriers that prevent competitors from easily entering their market.
Characteristics such as; patented technology, proprietary processes, switching costs, long-term contracts, scale of operations, and high capital costs; all contribute to raising the bar for competitors. Such key attributes of your company that would be attractive to a buyer must be properly communicated.
Industry Economic Conditions
The current economic conditions, long-term prospects, industry activity, commodity pricing, etcetera … can all contribute to buyer motivations. It is imperative that your advisor understands the nuances of your industry to expertly discuss the relevance of your company in the broader context of what is happening in industry.
How your deal is structured has a direct impact on value. Your advisor needs to work tirelessly to optimize proceeds and strike the appropriate balance of cash, vendor notes, earn-out and rolled equity.
We get asked this question a lot. Actually we are usually asked, “What kind of multiple is my business worth?”, but we will come back to that later. There are a number of different elements to take into consideration when determining the value of a business and a number of different methodologies to use.
First and foremost, it is important to understand what the seller is seeking in a transaction. If the seller wants to retain an interest in the business or benefit from future growth, then this is a risk-sharing approach which tends to generate a higher valuation.
Conversely, if a seller is interested in retiring from the business immediately and transition has not been adequately addressed, then the buyer is assuming more of the risk which generally leads to a lower valuation.
Clearly, the seller’s tolerance for risk will depend on their stage in life, their health, and plans after closing a deal. As such, the perfect deal for one seller may differ significantly from another.
With the seller’s transaction objectives in mind, the three main elements required to determine value are:
As the old adage goes, “cash is king”. Buyers focus on understanding historical and sustainable future cash flows from the business.
Significant emphasis will be placed on understanding your business plan, growth potential, capital requirements, staffing levels, facility requirements, scalability, industry cycles and anything else that could have an impact on the sustainable cash flows and profits generated from the business.
Recurring revenues stemming from factors such as customer loyalty, long-term contracts, and barriers to entry for competitors are manifested as stable profits and cash flows year-over-year.
Buyers spend a lot of time understanding the risks that can upset the forecasted financials so they can hone in on what they feel is a reasonable estimate of sustainable cash flow.
Rate of Return Expectations
Each buyer will have their own internal Rate of Return expectations that will need to be achieved in order for them to proceed with a transaction. This is typically a binary decision; based upon the projections for sustainable cash flows from your business, and how much risk the business endures year-over-year.
So based on the risk profile for your business and your business forecast, the calculated rate-of-return will either meet the buyer’s expectations—or it won’t.
There is a threshold that needs to be met for a certain level of risk. In other words, the higher the risk associated with the estimated future cash flows, the higher the rate-of-return required by the purchaser.
The third component of a company’s value is the balance sheet, which is required to operate the business as a “going concern”.
This includes the amount of working capital and capital assets required in order for the business to continue generating sustainable free cash flow. In other words, this is the permanent investment that is required to operate the business after a transaction closes.
If a minimum cash balance and accounts receivables have historically been required to keep the business operating, then these same amounts are likely going to be required post-close.
These items are negotiated terms in any transaction and have a tangible impact on how your company is valued.
What about EBITDA and EBITDA Multiples?
So, if the three aforementioned elements are the cornerstones of a business’ underlying value, why does everyone refer to EBITDA and “multiples” when discussing valuations or past transactions?
EBITDA is a simple term that generates a lot of confusion. Simply stated, EBITDA (is an acronym for Earnings Before Interest Taxes Depreciation and Amortization but the reason it) is commonly utilized is as an estimate of Cash Flow.
While it is quick and easy to use EBITDA to compare the financial performance of similar businesses, using EBITDA alone, as a proxy for cash flow has its limitations including, that there is no allowance for ongoing capital expenditures (which negatively impact cash flow).
So why is it so commonly used? It helps speed up the initial process of valuing a business, and relaying information in simple terms to partners, lenders, and shareholders.
It allows the buyer to understand EBITDA trends (up or down), EBITDA margin stability, and whether capex is spent in a prudent manner.
However, during due diligence, most buyers will consider the items excluded in calculating EBITDA in order to get a better understanding of cash flows prior to closing.
This is a fairly complex topic and if you prefer the technical details, we can talk about that. However, to answer the question we will focus on the context of how most sellers ask the question, “What kind of multiple is my business worth?”
The answer to this question depends on how EBITDA is positioned; is it a trailing 12-month EBITDA, weighted average, or is it forecasted EBITDA that is being used.
It is also important to understand whether normalizing adjustments have been made to EBITDA to add-back any one-time, out of the ordinary expenses incurred by the business.
You have probably gathered by this point, that EBITDA and “multiples” are not definitive terms. As such, your advisor will always seek to clarify the definition of EBITDA used by a Buyer in an offer, especially as it relates to performance targets for earn-outs.
In the context of selling a private company, preparing the business for transition takes, quite frankly a lot more time than many business owners anticipate. This task is often glossed over or underestimated by business owners but it is the #1 concern for buyers, so worthy of additional consideration.
Business transition is all about managing risk and no-one is more sensitive to this than strategic or private equity buyers. These players tend to follow the money, so to speak, as it relates to business transition – in essence, the managing shareholders are viewed as being responsible for the historic success of the business, and if they are still somewhat active in the business, they need to remain involved for what is deemed a “commercially reasonable” period of time after a deal closes. This is typically 2 to 3 years, and oftentimes, longer since the founding shareholders are the economic beneficiaries of the transaction.
The allure of enjoying a risk-free, clean exit from the business is pretty compelling, as an alternative to working in the business for the new owners for a couple of years. However, this sort of quick and clean exit is only possible in situations where (i) the valuation is sufficiently low to justify the risk being assumed by the buyer, or (ii) the founding shareholders have hired replacements for all executive functions within the business, and that management team has run the business for a period of time without interference or direct day-to- day involvement from the founding shareholders. In most businesses, this involves transitioning at least one and often two individuals into the business for each managing shareholder planning to exit the day-to-day operation.
Not wanting to accept a low valuation and guided by good intentions, the founding shareholders may hire a few key lieutenants which is a great first-step, but it doesn’t get those shareholders off the hook entirely. Furthermore, any executive you hire who is worth his or her salt is going to want some input into building the “dream team” to help transition the business.
Obviously, it takes time to recruit and groom a management team and any attempt to fast track the transition so you can exit quickly will be very transparent to any sophisticated buyer. In addition, it isn’t entirely reasonable to expect a business owner to invest 5 years to hire and groom an entire management team to reduce the perception of transition risk in their business.
Buyers recognize that the sale of a business involves many decisions, emotions, and a lot of soul searching. If you don’t have your transition plan 100% watertight, and the right buyer comes along or you decide to run a sale-process ….don’t worry about. It’s actually very common in mid-market deals to have some uncertainty as it relates to succession. Mid-market buyers are accustomed to dealing with this and in many cases, they are prepared to help with your transition plan, have resources available, and can begin working on that immediately after closing your deal.
Our advice is to continue running the business, and hire great talent along the way. When and if you tire of the day-to- day, make the appropriate decision either to hand over the reins to your management team, or to sell. Just don’t rush the hiring in order to expedite the selling because it won’t work.