A pleasant surprise for many business owners is the discovery that finding buyers for their businesses is not difficult. In good economic times and bad, companies want to make acquisitions. Perhaps buyers are willing to pay more in good times, perhaps companies with some blemishes will more readily find buyers in a frothy market, but the bottom line does not change: finding buyers is not difficult. Frankly, finding a buyer is the easy part. Closing a transaction that makes sense for the seller is the tricky part.
I suspect the reason for the surprise is due to the bias of our own experience. As anyone who has tried to sell a product or service knows, making a sale can be a very difficult proposition. What salesperson has not daydreamed about sitting on the other side of the table and making the buy decision? Therefore, when a business owner finds he is actively negotiating with a buyer (often in response to an unsolicited offer from a single buyer), the business owner believes the difficult part of the process is over.
In reality, the most difficult parts of the mergers and acquisitions (M&A) process are just starting: due diligence and purchase agreement writing. These final steps are where an inexperienced and unprepared seller can see the value of the transaction whittled away as a savvy buyer might attempt to renegotiate the agreement, with a lower valuation, of course. Defusing problems and fending off attempts to renegotiate agreements are where investment bankers earn their fees. And if a good one is hired, the investment banker will be worth every penny spent by the business owner.
A mistake some business owners make is to expect an investment banker to work some sort of M&A voodoo and get a buyer to magically increase an offer. Since most buyers are sophisticated they will reject an overture to negotiate against themselves. Investment bankers do not have magic words that they whisper in the ears of buyers to get them to increase their bids.
Instead, valuation is the intersection of competition, the strength of the underlying business, honesty, the want/need of the buyer, the motivation of the seller, the tenor of the times, and the skill of an investment banker.
Competition from an Orderly Sale Process
Running an orderly sale process means the investment banker will create competition. Competition breeds options and, in the hands of a capable advisor, can be a boon to valuation. Only after a suitable amount of competition has been created can an investment banker’s negotiating skills be fully leveraged to maintain and maximize valuation. Absent options born from competition, the ability to negotiate will be severely limited.
A seller who negotiates with only one buyer (or a very limited number of buyers) runs the risk of leaving money on the table. Would other buyers be willing to offer more? A seller will never know unless multiple offers are received. In an M&A process, all suitable buyers will be contacted, appropriate information will be provided at the right time, and interested parties will submit offers. This “clearing of the market” provides the seller with a full range of options.
Strength of the Underlying Business
A company with growing revenues, a strong bottom line, no customer concentration, and a strong management team will be more desirable than a money-losing company. If the fundamentals are sound, the seller can expect a good valuation. But just because the original offer is strong does not mean the seller will get to the finish line with that original valuation intact. Having multiple options means a seller has a far better chance of maintaining the valuation in the offer.
A sure way to scuttle a chance to put together an agreement is to mislead and misrepresent. Lack of honesty will very quickly ruin a seller’s credibility, thus tarnish the company’s valuation and perhaps make a transaction virtually impossible to close.
The Need/Want of the Buyer
A buyer who wants a particular company more than all others will be more likely to pay a higher price. The best way to find that buyer is by clearing the market, as discussed above.
The inverse of buyer need/want is the seller’s motivation to pursue a transaction. If a seller has few options and is desperate to do a transaction – any transaction! – that desperation will drive down valuation. A seller at the helm of a financially sound company with multiple offers in hand will be in a much stronger negotiating position.
Tenor of the Times
We are currently experiencing a rather frothy M&A market. Demand from buyers far exceeds the supply of companies coming to market and that is driving up valuations. I recently had lunch with a private equity professional who quipped, “6X is the new 5X.”
The reasons for the current situation are manifold and include a surfeit of liquidity created by the central bank’s loose money policy, excess capital on the balance sheets of corporations and private equity firms, and a low interest rate environment. Excess liquidity and cheap capital are inflationary and will drive up the valuations of companies. Low interest rates are also inflationary, but low interest rates have a compounding effect on M&A valuations. Low interest rates means fixed income returns are low which means a business owner will have a more difficult time replacing income from his company with income from fixed investments. This reduces the number of sellers which results in further upward pressure on valuations.
Skill of the Investment Banker
When I think about the transactions my firm has executed, the real value that we have provided a client comes in the final throes of due diligence and purchase agreement writing. Yes, the preparation of marketing materials and the creation of a buyers list are very important. Yes, the dissemination of those materials to the buyers is very important. But the biggest value, by far, comes during the final few days before closing.
What might seem like magic words is really the confluence of a multitude of occurrences, all orchestrated by the hands of knowledgeable and experienced advisors. Strong valuations can be had, but they are not the result of magic, they are the result of skill, foresight, planning, experience, and execution.
This is Lesson 4 of a seven article series about hiring an investment banker. In Lesson 5 we will explain how the “ask price” is determined. The previous article, Lesson 3, examined how to enhance valuation.
Link to Lesson 3: How to Enhance Value
Link to Lesson 5: The Ask Price
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