George leaned back in his chair, crossed his arms and tried to recover from the shock he felt at the number “$14 million” staring back at him from the paper. Much more than just a number, it was his investment banker’s assessment of the value of a lifetime of work that George and his wife, Claire, had invested in the company they started in college over 30 years earlier.
The company had paid for their kids’ education, a comfortable lifestyle, earned the respect of family and friends and provided for the livelihood of many families in the community. But, after a lifetime of pouring their hearts and souls into it, after teetering on the edge of insolvency twice when the economy took a downturn, and after seeing it finally grow again, it was disheartening to learn that all their sacrifices would not amount to more than $14 million. They were ready to sell their business, but only $14 million? How could this be?
George and Claire were not very different from most business owners who put it all on the line every day, always optimistic, always believing that tomorrow will be better than today. And like most business owners, they didn’t ask themselves some important questions, such as:
- How much longer do I want to keep running my company?
- Do I want my family to take over my business and is that a sound economic decision or an emotional one?
- What is my business worth today? What do I want it to be worth when I cash in my chips? What is my exit number?
- What do I need to do so my business is worth that number when I am ready?
If only they asked themselves the last question, business owners might see their strategic plans through a different lens and might make different decisions. Every decision not only has a different risk-adjusted near-term return, but it also has a dramatically different effect on the ultimate exit value of an enterprise.
Although many people spend a long time sifting through consumer research when buying a coffee maker or a camera, these same people don’t spend much time learning how to maximize the value of the very thing that takes up the better part of their working life—their business. So here’s a primer on the three main forces that drive the exit value of a business enterprise:
- Market conditions;
- The sale process; and
- Company-specific attributes.
While market conditions should not be the primary driver of liquidity timing, they should absolutely be part of the decision process. Financial markets go through cycles, bouncing from extreme conservatism to exuberant optimism with interest rates, risk appetite, and liquidity in the economy creating bubbles and undervaluations in M&A and capital markets.
For example, the same company that would have sold for 6x EBITDA in 2002 would have fetched 8x EBITDA in 2007 for the simple reason that the leverage that lenders were willing to provide in acquisition financing had risen two full turns of EBITDA. So, without even increasing the multiple of EBITDA that the acquirer was willing to fund in equity, that acquirer was willing to pay 2x EBITDA more because the lenders were willing to fund the increase. Everyone knows what happened in 2008 that caused the leverage pendulum to swing violently to the conservative side. But markets, like people, have short memories—it is now 2019 and leverage multiples are back to 2007 levels.
The Sale Process
It is astonishing how often we see business owners engage with potential acquirers who approach them without using an advisor and without running a competitive process or the threat of one. When institutional acquirers, such as private equity funds, sell their portfolio companies, they hire bankers and run competitive processes for the simple reason that creating competitive tension in a banker-run process maximizes value and minimizes risk. Without a competitive threat, a prospective acquirer has increasingly more leverage the longer the acquisition and diligence process take and, without intensive preparation prior to acquisition discussions, a seller is vulnerable to re-trading in price and terms by the unchallenged acquirer who brings well-trained advisors to show credible evidence in due diligence “findings” that warrant revised terms. Without the threat of competing bidders and triggers that allow the seller to terminate exclusivity, the seller is vulnerable, with little leverage to exert. Often, fatigued and unwilling to start the process from scratch with someone else, the seller relents and accepts inferior terms to reach closure and put the nightmare behind. The untold secret of banker-led, disciplined sale processes is that the winning bidder often pays as much as 20 percent to 50 percent more than the runner-up. That’s what a good process will do—it will identify the “must have” bid that will outdistance the “nice to have” bids. Saving the advisor fees is like sacrificing dollars to save pennies.
In the “behind the scenes” workshops we conduct to educate entrepreneurs we often put several business attributes on the screen and ask entrepreneurs to rank them in order of impact on a company’s value. These include factors such as management, financial metrics and performance, growth opportunities, addressable market, intellectual property, culture, regulatory risk, competitive moat, customer and supplier concentration, and many others. When we share the answers, the reaction is always the same: “We wish we had known all this when we made strategic decisions.”
For instance, just because a company has large profits or margins, it does not mean it will attract high valuations or acquirer interest or that it is even saleable. Conversely, just because a company has limited or no profitability, it does not mean that acquirers will not pay very high prices for the value of the brand or business model. Knowing how acquirers look at these attributes provides a valuable filter when making strategic decisions. Most importantly, conducting a thorough assessment of the “capital event readiness” a year in advance will allow the entrepreneur to prepare the company and make changes that could have a material impact on the value and process risk of the business.
George and Claire sold their company for $17 million through a competitive process that stretched the winning bidder well above the rest of the buyer pack. At the closing, they acknowledged that, if they were to do it all over again, they would have found a good investment banker years in advance of selling their business to use as a sounding board for key strategic decisions. Maybe the outcome would have been all the same, but at least George and Claire would not have been like Alice in Wonderland when lost in the woods, she asks the Cheshire Cat which direction she should go, and the cat answers: “that depends on where you are trying to get to.” As a business owner, ask yourself two questions: 1) “What do I want my company to be worth when I am ready to sell it? and 2) What do I need to do between now and then to make it worth that magic number?”