Thursday, June 24, 2010

Business Buyers are Valuation Experts

Business buyers do not ofter reveal their hands about why they feel a business is an attractive acquisition prospect for fear of driving up the price. They do, however, reveal those features that detract from a business' value in order to try to drive down the price during negotiations. This post discusses the value drivers and value detractors in a business sale transaction.

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 in this process. Without exaggeration, we 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 the statement, “We are pretty much industry agnostic.”

They may add in a couple qualifiers like we avoid information technology firms, start-ups and turn- arounds. Below is a typical description:
Example Capital Group seeks to acquire established businesses that have stable, positive cash flows and EBITDA between $2mm and $7mm. We will consider investments that satisfy a majority of the following characteristics:


Revenues between $10mm and $50 mm
EBITDA between $2mm and $7mm
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

I chuckle when I get these. You and 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. Pretty good chance that he will be successful in his transition to the pros. That is exactly what the buyer is looking for - pretty good chance that this acquisition will be successful once we buy it. Just give me a business that looks like the one above and even I would look good running 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 our 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 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 than 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? Below are our top 5 value destroyers:

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 risk 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.

A 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 from Dallas and he said to our client, “Brother, 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 you can both identify and fix your company's value detractors prior to your sale or you can let the new owner correct them and keep all that value himself. Viewing your business as a buyer would well in advance of your business sale and then correcting those weaknesses will result in a higher sales price and a greater percentage of your transaction value in cash at closing.

Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist

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