Selling a Business: How the BUYER Sees it.
If you’re selling a business, it would be a good idea to look at the business as a buyer will. This is particularly true when doing the valuation for the business.
A few weeks ago my post was about risk factors inherent in a business; and all businesses have some. When considering a business’ valuation, those risk factors must be taken into consideration because if the valuation is incorrect and the business is priced above its market value, it will either never sell or the seller will take what they perceive to be a significant haircut – and probably blame the broker.
But when valuing and selling a business, it’s important to realize that how the seller views these risks is different from how a buyer does.
A buyer buys what they believe is the business’ likely future earnings and the price any buyer is willing to pay for those earnings is based on how risky the buyer believes the projected earnings are. And every buyer has its own required rate of return.
If a buyer is willing to pay three times Discretionary Earnings, that buyer expects to get their money back in three years. The more risk the buyer sees in any business, the higher the return they will expect to compensate for that risk, and in turn the faster they will want their money paid back. Therefore, if the buyer perceives substantial risk to the business’ future earnings, the business valuation multiple applied by the buyer might drop from a 3 down to a 2.5 – or even lower.
On the other hand, if the risks to the business are extremely low, that multiple might 3.5 or even 4.
Look Through the “Buyer’s Eyes”
Business owners regularly minimize or even overlook some of the risks their business may face in the near future. But it is incumbent on business brokers to ask the right questions – questions that are designed to shed enough light on the possible risks that even the business owner will be able to see them.
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Few buyers will be happy with the status quo; they want their work and investment to have the chance to grow the business; to increase revenue and earnings. And to increase value.
Smart buyers have a rough exit plan in their mind when they buy.
Do they plan to sell in 10 years? If so, they ask themselves if they can grow the business to the size they want during their period of ownership.
To answer that question, they ask a bunch of other questions. These other questions are a way to assess risk. The seller is unlikely to look at their business in this way. But a professional business broker must, if the broker wants to be successful in finding a buyer.
Put on Your Buyer’s Hat
To properly advise our selling clients, we need to put on a buyer’s hat. We have to look at the business through the buyer’s eyes – which will enable us to help our client see their business how a buyer is likely to. This will go a long way toward arriving at a valuation that will entice one or more qualified buyers.
Buyers will almost always ask the basic questions:
- How big is the market for the product or service that the business delivers?
- What’s the potential for growth – for both the business and the market?
- Can the business be scaled?
But aside from these basic questions, a buyer will try to assess the risks to the business. Specifically, are there any potential risks to the business’ ability to generate the same levels of revenue and profit the business has shown over the past few years?
But a buyer will also try to assess the potential risks to growth.
Where Do Dangers Lurk?
Risk comes in many flavors, some of which – regulatory, tax burden (i.e., government-imposed) – cannot be controlled but must still be identified, if possible.
But there are many risks that, with a modest amount to consideration on the part of the seller and the broker can be identified and assessed.
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One of these key risks is owner dependence.
Is the business overly reliant on the owner? Is it dependent on the personal relationships the owner has developed over the years with the customers or clients? If so, the risk to the business’ performance post-sale is increased – and its value consequently decreased.
Data from nearly 60,000 businesses shows that businesses where the owner doesn’t have a personal relationship with the customers and rarely gets involved in the daily customer interactions get substantially higher offers than do businesses where the owner knows the name of most of the customers.
A business that has good people, systems and processes – and is not dependent on the owner – will be perceived as having less risk than a business with owner dependency – and is likely to receive a high value/offer from buyers.
The condition of “dependency” applies to other aspects of the business, as well, and can be equally damaging to a business’ value.
If the business has on over-reliance on one supplier, the risk to the business is high.
What would happen to the business’ bottom line if the supplier raised prices, suffered a disruption to its own supply chain, endured labor unrest or suffered any number of other setbacks? Earnings of the business you’re selling would, of course, fall. That’s also what would happen to its value.
In a similar vein, how much of the company’s revenue of contributed by its largest customer?
Best practice is to keep this below 15% of total revenue. Between 15% and 25% buyers begin to see red flags and valuations begin to soften. Much higher than that and alarm bells start going off.
This isn’t to say that such a business can’t be sold. But buyers will consider the business has a much higher risk factor and ultimately lower their valuation of the business and what they are willing to pay.
These are two examples of “concentration risk”. The more concentrated the source of revenue or the source of supplies, the greater the risk to the business. And the greater the perceived risk, the lower the value.
The Bottom Line
When selling a business, both the seller and the broker must look at it through the eyes of the buyer.
As a professional business broker, it it important to look at the business as if we were considering buying it ourselves. We do this all the time.
When we value a business, we’re generally the bearers of bad news. But we always ask a seller if they would buy their business at the price they are hoping to get for it. This always causes a slightly uncomfortable pause in the discussion. This is when the ability to defend your numbers is indispensable.
Step back and ask the hard questions. If the seller wants the business to sell – and if the business broker doesn’t want to waste their time trying to sell something that probably won’t – identifying and assessing the risk factors is crucial to success.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.