Value Is in the Eye of the Acquirer
Your business can be worth different amounts depending on whom you’re asking. Sure, you can probably look up a standard industry benchmark for valuing your company, but you can also look up the cost of an iPhone.
This is the art of selling a business. It comes down to how you package it, the story you tell about it, and the feeling it gives potential buyers when they imagine owning it.
Push vs. Pull
Most people would have you believe starting and growing a business is personal but selling is simply a business transaction. Yet selling your business is just as personal. The secret to looking back on your exit with fond memories rather than with regret is to get clear on your “pull factors.”
Pull factors are the things that you’re excited to go do next. What are you enthusiastic about diving into after you sell your business? That’s the most important question underlying this entire process— yet most founders never ask it.
By contrast, “push factors” are the things that are pushing you out of your business. Push factors can be anything that frustrates you about your company or takes a mental toll over time.
Deciding When to Sell
If you’re like a lot of founders, you’re probably trying to time the sale of your business when it peaks and coincides with the top of an economic cycle.
On the surface, timing your exit seems to make sense. If you speak with mergers and acquisitions professionals, they’ll tell you that an economic cycle can impact valuations by up to “two turns,” which means that a business selling for five times earnings at the peak of an economic cycle may go for as low as three times earnings at a low point in the economy.
The problem is, when you sell your business, you have to do something with the money you receive, which usually means buying into another asset class that is being affected by the same economy. Sure, you may diversify a bit, but most asset classes you’ll consider—from residential real estate to stocks to vacation property—generally move in the same direction as the economy.
Peak Seller vs. Trough Seller
For example, let’s compare two hypothetical sellers. Seller A and Seller B have identical businesses in the same industry, both generating $100,000 in pretax profit leading up to the Great Recession of 2008. To keep things simple, let’s imagine they were both living in a country that required no tax to be paid on the sale of a business. (A guy can dream, can’t he?)
Seller A sat stealthily on the sideline until the economy reached the absolute peak and sold his business for $500,000 (five times pretax profit) in October 2007. Seller A then took his $500,000 and bought into a Dow Jones index fund when it was trading above 14,000. Eighteen months later—after the Dow Jones had dropped below 7,000—Seller A would be left with less than half of his money.
Even though Seller A cleverly waited until the peak of the economic cycle, by March 9, 2009, having invested in the index, he would have effectively sold his business for less than 2.5 times earnings and would be left with less than $250,000 from the proceeds of his sale.
At first glance, Seller B waited too long and sold her business in early 2009—the trough, or lowest possible point, in the economic cycle—and got only three times earnings: $300,000. Yet notice that even in the trough, Seller B got 20% more than if she had sold at the peak like Seller A and bought an index fund at the top of the market.
The Seller A scenario is just like selling your house in a good real estate market; unless you’re downsizing, you usually buy into an equally frothy market. When you sell, you can’t put your money under your mattress, which is why timing the sale of your business on external economic cycles is usually a waste of energy
The other reason market timing is usually a mistake is that in most cases, you will have to help the new owner by staying on for a few years. Whether you sell to an individual, a private equity group (PEG), or a strategic acquirer, most deals will leave some of your money tied to future performance of your company. An individual investor will need you to finance some of the purchase price; a private equity investor will usually ask you to hold on to some equity; and a strategic acquirer will often use an “earnout,” where some of your money is tied to hitting goals in the future.
Regardless of how your deal is structured, you don’t want to navigate a transitional period in the teeth of a recession.
The Slow Reveal: How to Keep Control of the Process
Reveal too much, too early, and some buyers may lose interest. Others may place a value, even subconsciously, on your business long before you have romanced them with your entire story. Once a value has been calculated in the acquirer’s mind, it may be more difficult to get them to reprice your business later.
Just like a stripper, you must be in control of the dance that is selling your business. You decide when to reveal a new piece of information, and you never relinquish control of the process to the interested parties.
Your dance will start when your intermediary prepares a “teaser” document that reveals just enough about your business to tempt a group of buyers to sign an NDA. Once the NDA is signed, you’ll reveal a little more—including your financials and your vision for the future— in a detailed information package called a confidential information memorandum, or CIM. Then you’ll meet with potential acquirers, divulging even more about you and your team.
For now remember that information about your company is a form of currency, and as with money, you need to decide how to spend it.
The Danger of a Proprietary Deal
The opposite of a slow information reveal is a proprietary deal, where an acquirer takes control of the entire process and you’re left revealing everything about your business much too early in the process
Acquirers land a proprietary deal (or “prop deal”) when they convince you to enter into a negotiation to sell your business to them without creating a marketplace for it. Acquirers running a proprietary deal recognize that they do not have competition, and they tend to make weaker offers with more punitive terms because they know nobody else is bidding.
Possibly worse, when an acquirer knows they are the only potential purchaser interested in your business, they tend to drag out the process of evaluating your company and verifying what you tell them. This due diligence can last for many months in a proprietary deal, often resulting in the acquirer reducing their price at the end because they know you are exhausted by the process and have no other buyer to turn to.
Many founders become the target of a proprietary deal without even knowing they have been tricked. It can happen so easily. Someone senior from the acquiring company approaches you, complimenting you on your business. The acquirer suggests a meeting at a fancy restaurant. You agree, figuring, what could be the harm?
The danger is, you’re about to lose control of your dance.
Regardless of who courts you in a proprietary deal, expect them to be smooth. They will be easy to talk to and liberal with their praise of the company you have built. They may offer wine and work to slowly lower your defenses. They will try to make you believe they are your friend. Don’t believe them.
Asking “What” Questions
At some point in their courting of you, potential buyers will subtly start to ask questions about your business that you may not be in the habit of revealing over dinner—confidential stuff like your revenue, gross margin, and profitability. These are your privates, and you may not want to reveal them just yet.
Acquirers are just like consumers. They are drowning in messages and rely on shortcuts to process it all. They already have preexisting ideas of the kinds of companies they want to buy. Your job is to position your business as something unique in a category they’re already interested in.
This may sound devious, but it’s not. Positioning is one of the reasons selling your business is more art than science. Anyone can blandly recount your financial achievements and get an average acquisition offer, but your goal is to do better than average. That comes down to the narrative you weave about your business—and it all starts with how you position what you’ve built and what it can do for a buyer.
This is not about changing your company. It’s about changing the way acquirers perceive your company—and making sure they put it in the right bucket.
When an acquirer makes the decision to buy a company in a specific industry, the first thing they will likely do is perform an online search for the industry’s leading companies. Review your website, and ensure that it clearly positions you as a leader in the industry where companies are looking to make acquisitions. Then invest in SEO so you will naturally rank among the leading companies in that industry.
Also, consider becoming a more active member of your industry. If your sector gives out awards, toss your name in the ring. If your industry has a conference, volunteer to speak about something you do well. If your industry association has a board of directors, apply to become a member.
These actions will not only help new customers find you in the short term, but they will also position your company in the right bucket in the minds of acquirers when you’re ready to sell.
Understanding the Three Types of Acquirers
Acquirer Type 1: Individual Investor
If your business is on the smaller side—less than a few million dollars in annual revenue—it might be intriguing to an individual looking for an investment or seeking to replace a job they have recently lost or left.
It’s rare that an individual investor pays cash for an acquisition. Typically, in order to gather most of the money to buy your business, individual investors borrow from two places: a bank and you.
Instead of taking all of your proceeds in cash, when you agree to finance some of the sale, you offer to accept some of your money over time while the buyer uses your business as collateral for your loan. When it goes well, the buyer takes some of the profits from running your company and pays you back—often with interest
Therefore, strive to get as much cash up front as you can, and be clear on what you’re willing to do to help the new buyer learn your business. Plan to stay involved for a while to show them the ropes. Aim for a deal where you consider the portion of your proceeds from a sale that are being paid overtime as “gravy,” so if the buyer fails, you’re still satisfied with the transaction.
Acquirer Type 2: Private Equity Group
Another possible acquirer for your business is a PEG. This category can be further divided into three types:
- A fund, usually with multiple shareholders, that is set up to buy, improve, and flip companies (typically within five to seven years).
- A family office that is interested in investing money in a sector, usually on behalf of a wealthy family (or families), and often with no immediate plans to sell.
- A fundless sponsor—an individual or individuals who think they can raise the money to buy a business. This is usually someone who wants to own a business, thinks they can add value by operating it better than it’s being run today, and has contacts willing to financially back them if the terms are favorable enough.
PEGs are generally run by people who have already sold a business or have gone to a fancy business school. Their game is to find a business that is scalable or, in their view, is underperforming and could benefit from additional capital and more sophisticated management.
A PEG is in the business of buying low and selling high. To be successful, they have to acquire profitable companies for as little money as possible and use a lot of debt in the process. For their strategy to work, they need to sell your business at a much higher multiple within a few years, so push hard to understand what they plan to do to make your business more valuable.
Acquirer Type 3: Strategic Acquirer
A strategic acquirer (or simply “a strategic” in M&A parlance) is a company with assets that become more valuable if they own your business. When considering the right buyer for you, ask yourself: Is there a company in your industry that could compete more effectively if they acquired your company?
Your business may be strategically valuable to another for a lot of reasons, but here are some of the most common things that owning your company will allow a strategic to do:
- Win more business from their competitors
- Differentiate their offering
- Enter a new market
- Capture more market share, and therefore raise prices and be more profitable
- Improve profit margins by spreading their overhead across more revenue
The strategic acquirer is not a person; it’s a thing. It’s an organization run by a CEO who reports to a board with the primary responsibility of maximizing value for their shareholders. Unlike other acquirers, a strategic acquirer is—and always will be—in love with their company.
Thinking a strategic acquirer will help you reach your goals through their resources is the wrong way to approach them. The strategic acquirer is focused on their business, products, and people. Although you may care deeply about your company, they don’t feel the same and likely never will. Instead, they want to know how owning your business will help make theirs more successful.
Continue to keep your mind open to the idea of being acquired by any one of a range of buyers. The more appealing you are to a range of buyers, the more likely you are to draw multiple offers, which is the secret to maximizing your company’s value in a negotiation.
The 5-20 Rule of Thumb
So how long is your list of potential acquirers?
If you feel like you need to do some pruning, one of the best ways to shorten your list is to apply the 5-20 Rule: the most likely buyer for your company is often 5 to 20 times the size of your business today.
Let’s break down the 5-20 Rule into its two components, starting with the premise that your natural acquirer is likely to be at least five times the size of your company. Why does an acquirer have to be so much larger? Whatever happened to the idea of a “merger of equals”?
Acquiring a business can be a risky proposition, and buyers understand this. When they make a play for your company, they need to know that if it fails, it won’t bring down their entire business. There is also the obvious fact that a company needs to be substantially larger than yours to have the cash (or the ability to borrow it) in order to buy you.
Why No More Than 20 Times the Size?
Now let’s look at the second part of the 5-20 Rule, which is that your natural acquirer is not likely to be much more than 20 times your size.
This comes down to the simple fact that most companies with an appetite to acquire businesses can digest only a small number of acquisitions per year, and they would rather spend time on the ones that will actually make a difference.
The 5-20 Rule allows you to filter your long list and identify the companies most likely willing to make an acquisition offer. However, think of it as a “rule of thumb” rather than a law that is written in stone. There are examples of acquisitions that fall outside the 5-20 Rule, but they are somewhat unusual. You don’t need to take a potential acquirer off your list just because they fall outside of the 5-20 Rule. Just know that an acquisition offer from them would be somewhat unusual.
Crafting Your Teaser
Selling a business is a form of art, and if every great piece of art tells a story, think of your teaser as your introduction. It’s a written summary of your business that positions it in the mind of an acquirer.
Typical sections include those listed below.
- Summary: Start with a short description of your business, positioning your company in an industry that you know acquirers are keen on. Think of this as a 30-second commercial, but instead of selling your product, you’re selling your company. Your summary should succinctly answer questions like the following:
- What product and/or service do you sell?
- How do you make money?
- When was your company founded?
- What industries do you sell to?
- What is your distribution model?
- Financial highlights
- Investment highlights
- Team of employees
- Reason for the transaction
How to Explain Why You’re Selling
You’re tired, sick of managing employees, and burnt out. You have some new and exciting things you want to go do. You want to hand the keys to a buyer and run the other way.
“I’m really good at starting businesses, but scaling them has never been my strength. I’d like to find someone who can take what we’ve started and build it into something great.”
You’re ready to retire or your health is starting to suffer.
“While I’ve still got a lot of passion for my business and energy to support a transition, I’m at an age where I’m starting to think about retirement.”
You want to cash out, but you’re willing to hold some of your equity and remain involved as a shareholder after a transaction (i.e., a private equity deal).
“We’re at a point where we’d like to find a partner with the financial and strategic resources to help us capitalize on the opportunities in front of us. For me, I’d like to diversify my personal balance sheet a bit, but I’d very much like to remain a significant shareholder going forward.”
You’ve been approached with an unsolicited acquisition offer, and you’re curious who else might be interested in buying your business.
“We’re not looking to sell, but we’ve been approached by an acquirer. Before we go too far down the road with them, we wanted to look at where the strategic fit might be the strongest.”
You want to attract an investor, but you’d be open to an outright acquisition.
“We’re looking for a strategic partner who can help us get to the next level, and we’re open to structuring a deal in whatever way makes the most sense.
Right vs. Best
If you foster a transparent culture and you decide to sell, you’ll start feeling like a cheating spouse, skulking around the office with a giant secret nobody knows about. The guilt may even become paralyzing.
The morally “right” answer is to tell your team—but that is one of the single biggest mistakes you can make in selling your company. This book is about your endgame, and randomly telling your employees you’re considering selling is almost always a catastrophic mistake. Here’s why.
- Some deals fall apart.
- Employees get rattled when they know you’re selling.
- Panicky employees often leak the news to industry people.
- If your results slide, expect your price to go along with it
- Deals morph as they progress.
- You’ll need everyone on board to hit your earnout.
- You may decide not to sell.
Consider the following set of questions before you get swallowed up by guilt:
- Do you pay a market-rate wage?
- Do you offer employees a safe working environment?
- Do you promote people when they do well and provide coaching to those who are struggling?
- Do you provide decent benefits?
- Did you personally risk much or all of your life savings to create your business?
- Were there occasions when you sacrificed time with friends and family because your company needed you?
If your answer to all of those questions is “yes,” then you’ve delivered on your end of the employment bargain, and you don’t owe your employees advance notice of a potential sale. No, not all of your employees will see it that way, and some will feel betrayed when they find out you have sold. That is their problem—not yours.
What’s Your Business Worth?
Entire textbooks have been written on business valuation. Let’s just tackle the three most common ways you can estimate the value of your business.
The most basic way to value your business is to figure out what your hard assets are worth and subtract any debt you have on your business.
Imagine a landscaping company with trucks and gardening equipment. These hard assets have value, which can be calculated by estimating the resale value of the equipment minus any debt.
This valuation method often renders the lowest value for your company because it assumes your company does not have any goodwill. In accountant speak, goodwill has nothing to do with how much people like your company; goodwill is defined as the difference between your company’s market value (what someone is willing to pay for it) and the fair market value of your net assets (assets minus liabilities).
Typically, companies have at least some goodwill, so in most cases you’ll get a higher valuation by using one of the other two methods described below.
#2 Discounted cash flow
In this method, the acquirer is estimating what your future stream of cash flow is worth to them today. They start by trying to figure out how much profit you expect to make in the next few years. The more stable and predictable your cash flows, the more years of future cash they will consider.
Once the buyer has an estimate of how much profit you’re likely to make in the foreseeable future, and what your business will be worth when they project selling it, the buyer will apply a “discount rate” that accounts for the time value of money. The discount rate is determined by the acquirer’s cost of capital and how risky they perceive your business to be.
Rather than getting hung up on the math behind the DCF valuation technique, it’s better to understand the drivers you can control when an acquirer uses this method. These are determined by your answers to the following questions:
- How consistent have your profits been, and for how long?
- How much profit do you expect to make in the future?
- How reliable are those estimates?
Another common valuation technique is to look at the value of similar companies that have sold recently or whose value is more or less public knowledge because of industry standards. For example, accounting firms typically trade at one times gross recurring fees. Home and office security companies trade at about two times monitoring revenue; most security company owners know the comparables technique because they often get approached by private equity firms rolling up small security firms. You can usually find out what companies in your industry are selling for by asking around at your annual industry conference.
The problem with using the comparables methodology is that it often leads owners to make an apples-to-bananas comparison. You may compare yourself with a similar company in your industry that just sold, but without an intimate understanding of their business, you may be drawing a comparison that isn’t there. Private companies are just that—private. That means you can estimate things like their profit, gross margin, and growth rate, but unless you have insider knowledge, you will just be guessing.
So to avoid guessing, owners often look for public comparables information, which leads to comparing themselves to a large publicly traded company in the same industry—and that is a recipe for regret.
For example, because medical technology companies generally trade for 20 times last year’s earnings on the New York Stock Exchange (NYSE), a small medical device manufacturer might think they too are worth 20 times last year’s profit. However a small medical device manufacturer is likely to trade at a fraction of 20 times. Small companies are deeply discounted when compared with their large, publicly traded counterparts, so measuring your company’s value against a Fortune 500 giant will often lead to disappointment
What’s Your Business Worth to You?
Philosophically, what your business is worth to you is a much trickier question. There are many intangible benefits to owning a business; these are hard to quantify. For example, what’s it worth to be recognized as an important member in your community when you walk down Main Street on a Saturday morning? What’s it worth to see a job well done, knowing you made it possible? How do you value the feeling of pride you get from employing someone who might have trouble finding a job elsewhere?
Similarly, owning a business involves a number of intangible costs that may drag down its value in your mind. For example, what does it cost you emotionally to worry about your business every day? What’s the psychological toll of having to let someone go? What’s the cost of the stress you endure knowing most of your net worth is tied up in your business? What’s the price of having to check your mobile phone while you’re on vacation?
Weigh these intangible benefits and costs, and do your best to calculate what your business is worth to you.
Nudging Acquirer to Increase Their Offer
#1 Clarify Your BATNA
First, you need to get clear on your best alternative to a negotiated agreement (BATNA)—in other words, your plan B. The stronger your BATNA, the more leverage you have over an acquirer
Your BATNA could be an offer from a PEG to recapitalize your company. Or perhaps it could be a plan to sell the company to your management team, or a willingness to keep running your business rather than selling it. The happier you are to hold on to your business, the more leverage you have in a negotiation.
Provided you’re comfortable with your BATNA, one approach to driving a better deal is to simply ask. Let the prospective acquirer know that, compared with the other offer on the table, theirs is a little light. Explain how excited you are about the synergies between the two of you, and let them know they’ll need to do a little better if they want to acquire your business.
#2 Quantify the Acquirer’s Upside
Another way you can attempt to get an acquirer to increase their offer is to quantify how they will benefit from buying your business. This is a process the acquirer will do on their own, but based on the knowledge you have of your company and industry, you may be in a better spot to point out other synergies they may not have thought of.
Your goal should be to understand what your acquirer is trying to achieve and to show them how owning your business helps them accomplish their goal. Remember, the acquirer is just as myopic as you are about your company; they will react more favorably if you can show them how owning your company helps them sell more of their product.
#3 Quantify Your Value
Some of the most common reasons businesses make acquisitions are to give them the following:
- A point of differentiation for their marketing
- A leg up in competing with their archenemy
- A big enough share of the market to control the price of a key product or service
- Access to a new market
- A way to save money
- A new list of customers for their product
- A way to improve margins through volume discounts or rebates from their suppliers
At this point, you need to fire up a spreadsheet and attempt to quantify the strategic value of owning your business. Show an acquirer your math, and run scenarios that demonstrate how— even in the worst case—they will make out like bandits by buying your business.
#4 Kill Them with Kindness
One final word on maximizing any offer you get: no matter how low an offer is, try to work with it.
When you get a low-ball offer, you may feel a wave of righteous indignation rise up from your belly. You may find yourself cursing a prospective acquirer under your breath, enraged by how little they respect what you’ve built.
Let your emotions boil, but don’t reveal your disgust to the buyer. The art of selling well is to take any offer—no matter how low—and try to nudge it up.