Over the past year, our company has been evaluating a number of potential acquisitions as part of our partnership with Acceleration Partners, a private equity firm. Unfortunately, as we engage with many first-time sellers in the process, it has become clear that many founders do not have an accurate understanding of what their company is worth to a buyer.
Understanding the Value of Your Business Isn’t Intuitive
Not knowing the exact value of a company is a situation I found many years ago before seeking advice from experienced owners who went through this process. But, unfortunately, understanding the value of your business is not intuitive.
Many founders, unfortunately, insist on the wrong metrics, turn off the interest of potential buyers, and lose focus on the business itself.
The Number One Thing That Determines the Selling Price of Your Business
If you’re serious about selling your business, one metric matters above all else: market-clearing prices for similar businesses in your industry.
It’s easy for entrepreneurs to overestimate the value of their business, but financial and strategic acquaintances rarely share that rosy outlook, because they have a broader perspective. So at the end of the day, you need to know what kind of prices are actually paid for companies like yours—the transactions that get closed.
If you enter the acquisition market with an unrealistic sense of the value of your business, you’re not going very far.
Here’s how you can best estimate the right price for your business and avoid going over the offer you’ve been waiting for.
know your stripes
While no two businesses are exactly the same, the value of a business generally depends on three things: its industry, its size, and its business/pricing model.
For example, almost all professional services businesses are valued based on their level of profit; They usually do not own proprietary property or intellectual property and make money from their people, who are never guaranteed to live.
how to calculate
An acquirer will often calculate the offer for a service business by multiplying the company’s EBITDA, or earnings before interest, taxes, depreciation, and amortization, for the past 12 months.
In valuation shorthand, this is referred to as TTM EBITDA, or trailing-twelve-months EBITDA. It is a proxy for the annual cash flow that a business generates before servicing a loan. Businesses with high levels of TTM EBITDA tend to receive higher multiples, especially as EBITDA crosses the $5/$10/$20 million range.
Within service businesses, there is another important difference: project-based businesses and recurring-revenue businesses.
Project-Based Businesses: Constantly bringing in new customers or projects, it must refill its revenue stream each year, so revenue is less certain from year to year and requires more sales and marketing effort.
Recurring-Revenue Business: There is a lot of long-term forecasting and there is no need to constantly acquire new clients and projects to maintain revenue and profitability.
Here’s an example of how this difference appears in the real world
For a marketing agency, a project or campaign-based services business with $1 million in TTM EBITDA and $15 million in annual revenue would be valued at 3X to 5X EBITDA, or $5 million at the high end.
The company, on the other hand, is a tech-enabled services business with long-term contracts that result in 90 percent recurring revenue and $5M in EBITDA. Company B also has the same annual revenue of $15 million and can be valued at 10X EBIDTA, or $50M.
This business has much better margins and a recurring revenue model that provides greater certainty on future revenue and profits.
If the founders of Company A walk into the market assuming they will be valued the same as their friends who founded Company B – they will be very disappointed.
Company A does not have sufficient scale, sufficient profitability or the right business model to control Company B’s premium 10X multiplier; And it is very risky for a buyer.
When selling your business, remember that the potential buyer is often a larger, more established company in your workspace.
When selling your business, you may be selling private equity or to an investor who has seen what works and what doesn’t in your industry.
In short, a knowledgeable buyer will look at your business’s core offerings and finances and know how you measure up to other acquisitions in your area. To attract these buyers, you need to know what your industry is worth and understand how your company’s size and pricing model checks in.
Just as an animal knows its own kind by matching its stripes, you need to make sure you’re comparing your business to the right companies.
Understand your true financial picture
Many business owners do not understand how a potential buyer will interpret their financial picture, especially when it comes to profits. As a result, in some cases, they may fail to account for certain expenses and make excessive estimates on how a buyer will measure their profit.
For example, a founder may show investors a business with $500,000 in annual profit, only to later discover that the founder takes a salary of only $50,000 and derives most of his income from profit distributions.
This calculation and misrepresentation to buyers or investors can be a big problem.
If the founder role has a market salary of $200,000, and he or his replacement must continue to earn that income when the deal closes, increase the cost structure to $150,000 to pay the leader’s salary to the new owners. Will happen.
While this company showed a profit of $500,000 on its income statement, its actual profit, or adjusted net profit, is $350,000. When you factor in the 5X multiplier, that’s a valuation difference of $750,000.
Common Events of an Entrepreneur Salary
The following is a common occurrence – 51 percent of entrepreneurs do not take a salary while starting their business.
This type of financial misinterpretation can derail a promising deal when the enterprising business owner isn’t drawing a salary.
Before sharing financials with a potential buyer, work with your accountant or transaction advisor to develop a clear adjusted net profit that gives buyers an accurate first impression.
Also, consider taking a market-based salary for your role, rather than offsetting the lower salary with benefits, as this will save you headaches and give you a more accurate picture of your business.
Be aware of the reference actual market clearing price and the terms of the deal
Two other common factors cause owners to overestimate their businesses and raise their expectations.
In some cases, founders get caught up in rumors of deals in their industry without knowing the full context of those acquisitions.
Most of the press and available data pertains to very large transactions. In other instances, an owner uses the price of another deal as a baseline—even though the referenced transaction was never actually closed.
Think: The Rumor—Until Verified
Just as your social media feed will only show you the best five percent of others’ lives, the rumors and tall stories you hear about pricing often give a distorted view. In some cases, people simply embellish the truth; In other cases, they will share the total enterprise value of the deal and not the specifics of the deal.
For example, there’s a big difference between a company that sells for $10 million in cash and one that sells for a $10 million price tag, but with a $5 million cash advance and five-year earnings.
In the latter case, only the initial $5 million is guaranteed; The balance is paid from future earnings and you may need to grow the business to a specified income level to be employed for that period or to achieve this, effectively meaning a lower valuation multiplier.
In long-term earnings, you are essentially paying for the business yourself from future profits, not the acquirer’s money.
It is also wrong to assume that a proposed deal represents the actual market value. For example, the Harvard Business Review found that between 60 and 80 percent of proposed acquisitions fail to close.
A large percentage of proposed acquisitions fail to close because many acquirers, unfortunately, practice making artificially inflated offers to acquire a business under the agreement.
The business can then plan to “retread” the seller prior to closing or change the material terms of the deal after a lengthy due diligence process.
At that point, you must either agree to the new terms or leave nothing at all – after investing so much time and effort. You want your business to close the deal, and this is the best reason to objectively present your financial picture, as any deviation gives the acquirer ammunition to “retaliate” the deal.
Pay attention to market clearing prices
Again, this is why it is best to focus on market-clearing prices. Next, look for verification – which is the actual value of the deals that were actually closed. Otherwise, you’ll base your expectations on stories that often don’t match reality.
At the end of the day, if you want to sell your business, you must go to the market with the right expectations and assumptions.
With accurate expectations and assumptions, you will have your financials in order and an understanding of actual market clearing prices and conditions for businesses in your industry and your size.
What is the most important issue for you?
Price may not even be the most important aspect of the deal, depending on what you want to do next and how much freedom you want.
Conclusion—consult your values
And last but not least, be sure to consult your values to make sure the acquisition you’re getting is the result you want, and that you’re partnering with the right team. To paraphrase Warren Buffett, you can’t treat the wrong person well and treat the right person badly.
by Robert Glazer
This News Originally From – The Epoch Times