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 article 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. An M&A 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 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 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 M&A 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 M&A 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 Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital
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