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

Monday, June 21, 2010

Bridging the Valuation Gap between Business Seller and Business Buyer

Statistics show that a surprisingly low percentage of businesses for sale actually sell during their first attempt. The major reason for that is the valuation gap between the buyers and the seller. This post discusses how that gap can be breached resulting in completed business sale transactions.

In an earlier article we discussed a survey that we did with the Business Broker and the Merger and Acquisition profession. 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 3 years of going to market. That is a 90% failure rate.

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. A Mergers and Acquisitions firm that fails to complete the sale of a client, even if they charged an up-front or monthly fees, 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.

We explored a number of options including preparing a mock letter of intent to present to the client after analyzing his business. This mock LOI included not only transaction value, but also the amount of cash at closing, earn outs, seller notes and any other factors we felt would be components of a market buyer offer. If you can believe it, that mock LOI was generally not well received. 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 earn out payment. Our client was adamant that this structure would be a non-starter. Fast forward 9 months and 30 buyers that had signed Confidentiality Agreements and reviewed the Memorandum withdrew from the buying process. It was only after that level of market feedback was he willing to consider the message of the market.

We decided to eliminate this approach because the effect was to put us sideways with our client early in the Mergers and Acquisitions 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 1 X revenues," or, "We invested $3 million in developing this product, so we should get at least $4.5 million."

My unspoken reaction to these comments is that 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, when our client brings us an example of IBM bought XYZ Software Company for 2 X revenues so we should get 2X revenues.

It is simply not appropriate to draw a conclusion about your value when compared to an IBM acquired company. You have revenues of $6 million and 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 small companies.

When I say my unspoken reaction, please refer to my success with the mock LOI discussed earlier. So now we are on to Plan C in how to deal with this valuation gap between our seller clients and the buyers that we present. Plan C turned out to be a bust also. Our clients did not respond very favorable when in response to their statement of value expectations we asked, "Are you kidding me?" or "What are you smoking?"

This issue becomes even more difficult when the business is heavily based on intellectual property such as a software or information technology firm. There is much broader interpretation by the market than for more traditional bricks and mortar firms. With the 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 Mergers and Acquisitions process. In these companies where there can be broad interpretation of its value by the market it is essential to conduct the right process to unlock all of the value.

So you might be thinking, how do we handle value expectations in these technology based company situations? Now we are on to Plan D and I must admit it is a big improvement over Plan C (are you kidding)? The good news is that Plan D has the highest success rate. The bad news is that Plan D is the most difficult. We have determined that we as Mergers and Acquisitions professionals are not the right authority on our client's value, the market is.

After years of what are some of the most emotionally charged events in a business owner's life, we have determined that we must earn our credibility to fully gain his trust. 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 should be totally satisfied that we have brought him the market. If we can get to that point, the likelihood of a completed transaction increases dramatically.

The client is now faced with a very difficult decision and a test of reasonableness. Can he interpret the market feedback, balance that against the potential disappointment resulting from his preconceived value expectations and complete a transaction?

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

Saturday, June 05, 2010

The Importance of Reasonableness When Selling Your Business

Sometimes business owners are their own worst enemies in the sale of their business. this post explores the importance of reasonableness for a business seller.

We recently completed a survey of a broad cross section of business brokers and merger and acquisition professionals. One of the questions we posed was, “What is the biggest challenge you face in your practice?” We gave them eight choices including lack of financing, sell side deal flow, not enough buyers, etc. We asked our professionals to pick their top three. The top answer was Seller Value Expectations with a 68.9% response rate. The next closest answer was sell side deal flow at 55.3%. Why is this the biggest challenge that our industry faces? To me this translates into a great deal of wasted effort on the part of our buyers, our seller clients, and our profession.

This is further exacerbated by the business sellers that expect a full business sale engagement with no monthly fees and the only payment in the form of a contingent success fee. A true professional M&A engagement includes preparation of blind profiles, confidentiality agreements, memorandum authoring, preparing a database of buyers, buyer contact, conference calls, buyer visits and negotiations. A typical business sale takes between 4-12 months and often involves from 500-1,000 hours of Investment Banker work.

Because deal flow is the second largest problem that the industry faces, many business brokers and merger and acquisition professionals will agree to this success fee only seller demand. I believe it was Rockefeller that said, “If it seems too good to be true, it probably is.” One of the large industry players estimates that the average business sale closing ratio is less than 10%. This is so important that I am going to say it again. The business sale closing ratio is less than 10%. It fails 90% of the time.

Let's look at the natural result of this dynamic. The business broker, if he is doing it the right way, is going through this very labor intensive process to contact buyers, get confidentiality agreements signed and bring qualified buyers to the table. Here is what typically happens. The owner is getting all of this work for free, has unreasonable value expectations and since he is not paying any fees, has no sense of urgency. The broker could bring in legitimate market offers that are fair and the owner says, “That is not nearly enough, you are doing fine, just keep going.”

Well it doesn't take a business broker too many situations like this before something has to change. The first thing that usually changes is that he now refuses to take on any engagements without an up-front payment or a monthly consulting fee to offset some of his costs in this low closing environment. What happens over the next year is that his deal flow totally dries up, because he is competing with those professionals that are still willing to operate with only a contingent success fee.
The next question is how do those brokers that operate on a contingency basis stay in business?

The simple answer is that they can no longer afford to perform a true M&A process. They take on a large number of clients and try to sell their business through newspaper ads, industry publication ads, email blasts to private equity groups, email blasts to other brokers and the favorite - putting the business on several business for sale Web Sites.

All of these approaches, with the exception of contacting private equity firms (about 1 % of businesses for sale meet their rigorous buying criteria) invite individual buyers, not corporate buyers. Individual buyers are looking to buy a job and to the extent that business sellers have inflated value expectations, these buyers have equally deflated valuation expectations. It looks something like this. Do you have the $XXX minimum needed for the cash at closing? No but I have investors. These investors never show up.

The individual's analysis follows this logic. Well, at the height of my career, I was making $150,000, so I am going to have to get at least that out of the business each year. Also, because this is high risk, the equity I put in will command a 25% return, and I have to cover the 75% of transaction value debt at 10%. So, by my calculation I can afford a price of 60% of what the true market value of the business is.

This gap is almost never bridged between business seller and individual buyer. And yet the approach most of the business broker profession is forced to take based on the unreasonable expectations of the sellers invites this dynamic. This is often hugely damaging to the seller's business. No matter how much he tries to focus on running his business, this stream of bargain hunters is a big drain. The business often suffers a significant drop in performance during this period, and like an overpriced home, often becomes stale in the process.

As the owner of a Main Street Business - bar, restaurant, salon, convenience store, gas station, etc. the economics and the likely universe of buyers really dictate this approach. Just be prepared for this process and at least have your non-paid broker screen out the totally unqualified buyers.

For owners of B2B type businesses and larger businesses, your buyer will not be an individual, but rather a corporation or a private equity group. Let's focus here on the corporate buyer. If the potential buyer is under $50 - $100 million in revenue, the M&A contact is usually the president. If the company is larger, it usually will have the initial deal vetting completed by the head of strategy, business development or mergers and acquisitions. Those people are not visiting business for sale Web Sites or searching the business opportunities section of the newspaper.

The business owner's first reasonableness hurdle is whether he/she recognizes that to reach these corporate buyers is a very difficult and labor intensive process and a firm that specializes in reaching these targeted buyers is the right choice to hire. These professionals normally require either an up-front fee or a monthly fee in addition to the contingent success fee.

Well, you did it. You interviewed several firms, checked references, felt comfortable with their process and felt confident with them as you partner for the next 6-9 months. Your M&A firm takes you to the market and gets several companies interested. You arrange multiple conference calls and corporate visits and then the subject of value comes into focus. This is where deals usually break down. There is a natural valuation gap between buyer and seller and the challenge becomes how to bridge that gap with both valuation and deal structure. The seller's reasonableness will be put to the test as he tries to balance his emotions with the ultimate arbiter of value, the marketplace. But that is the subject of a future post.

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