Valuing a Business: The Buyer's Perspective

 

Valuing a Business: The Buyer's Perspective
Last updated: 10/25/2007 View printable version

 

 

Often times, public company data is used when attempting to value a privately-held firm. This comparison usually requires substantial adjustments to offset the risks inherent in the privately-held or closely-held company. These potential risk characteristics are usually elements that are overlooked by sellers, but not by potential buyers.

 

Sellers obviously look at their companies much differently than do prospective acquirers. Owners and company officers tend to place value on different factors than a buyer. However, when it comes time to sell, it's important that the seller consider those factors that are important to a buyer.

 

Interviews with buyer prospects reveal that they are concerned with, and influenced by, the factors outlined below. They are often the basic considerations that determine whether they actually purchase the business, as well as the price they are willing to pay. It is the buyer's evaluation of these factors that can make or break a possible sale.

 

Buyers tend to look at these elements as risk factors. They also look at the expectation of future earnings. The following characteristics affect, both positively and negatively, the future earnings potential of and the risks involved in a target business.

 

Historical Earnings

 

The history of a company's earnings is very important to a prospective buyer. A long history of stable, and hopefully increasing, earnings is a positive factor in whether the buyer will pursue the acquisition.

 

Conversely, a brief history or inconsistent earnings will certainly be a negative factor. A short time frame (for example, a company that has been in business for a year or less) and erratic earnings present obvious risk factors.

 

Entrepreneurs often underestimate the costs (and time) necessary to get the company to a profitable level.

• Start-ups are difficult to sell under the best of circumstances.
• The next time period in the life of a business is after three years, at which point there is some history, and a track record is beginning.
• The third period is usually after the company has been in business for a minimum of five years. Now the company has a track record and a reasonable history of performance.

 

Growth Prospects for Both the Business and Industry

 

If the buyer is from the same industry, then he or she should already have the answers to these questions. If the buyer is from a different industry or business type, then these are very important issues.

 

Certainly, no one can predict the future, so these issues are subjective at best. Thanks to the Internet, however, information is much easier to obtain than ever before. If the buyer perceives the target business to be in a growth industry, then the valuation can be considerably higher than one that is not.

 

Depth of Management

 

Just as a skilled and well-trained workforce commands a higher value, so does strength and depth of management. Generally speaking the smaller the company, the less depth of management.

 

A business that is primarily dependent on the owner or a manager will bring substantially less in the marketplace than one that has key management in place. Many prospective purchasers also want more than one layer of experienced management in place.

 

Some buyer concerns about management:

 

Will top management stay beyond any contractual periods?
Is the current management motivated and what incentives do they need?
Are current management values, etc., consistent with the buyers?
Does current management have the leadership skills to move the company forward?
Is the depth of current management sufficient to fulfill projected growth plans?
Is current management able to handle change?
Employee Stability

 

Well-trained and skilled employees are a big asset. National studies indicate that over 50 percent of employees are unhappy with their jobs. Having a skilled and happy workforce in place is especially important for new owners without industry experience.

 

Prospective purchasers are equally concerned with the high-cost of finding, hiring and training new employees. For these reasons, companies with a well-trained, skilled and contented workforce will command a premium value. Companies that utilize low-skilled employees and have high employee turnover will bring a much lower price.

 

Terms of Sale

 

Is the company solid enough to support debt financing as opposed to equity capital? Are the company owners, if privately owned, willing to help finance the acquisition? The answers to these questions impact value. The availability of capital can be a significant factor in increasing the value to an acquirer.

 

Diversification

 

Diversification has two elements. The first is the diversification of products or services. Can they be readily expanded? Do the products or services just fill a niche and therefore limit expansion? What limitations does the company have, such as customer or supplier restrictions?

 

The second element is geographic. Providing the product or service on a national level certainly increases value and decreases the risk to the buyer. Conversely, only local or regional distribution reduces value and increases risk.

 

Industry characteristics that increase value

 

Industries with strong trade or professional associations
Industries with low failure rates
Industries with any type of regulation, licensing, patents - anything that might restrict the amount of competition
Industries with established products or services coupled with stable pricing

Competition

 

Companies in very competitive industries may have less value than ones with little or moderate competition. Heavy competition can lead to lower prices creating lower volume and profits. However, concentrated competition, for some businesses, such as auto dealers clustering in auto malls, can actually increase sales.

 

Business Type

 

This element is most likely to be in the "eyes of the beholder." The buyer's perception of risk may focus almost entirely on the type of business or industry. Businesses that are easily started obviously have less value than those that are equipment/capital intensive or require very skilled workers or specialized knowledge. Industry trends can play an important role in the value of a business.

 

Some industries seem to be simply more "popular" than others. Manufacturing represents less than 10 percent of all businesses, but the demand for this type is very high. The demand for retail businesses that must compete with the large "box" stores is very low.

 

Location and Facilities

 

A well-located office and/or facility will, at least psychologically, increase value. Well-maintained fixtures and equipment will definitely increase value. Everything else being equal, an attractive plant with well-maintained equipment located on the "right side of the tracks" will have a higher value than one without these advantages.

 

Summary

 

The business characteristics described above outline some of the pitfalls or risks in using public company data when looking at the privately-held or closely-held company. Buyers obviously - and sellers certainly - should be aware of the factors or characteristics described above as they heavily influence the ultimate value of a company, the time it takes to sell, and sometimes whether it will sell at all.

 

Note: Much of the above information is based on an article contained in the Mergers and Acquisitions Handbook of Small & Midsized Companies, published by John Wiley & Sons.

 

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