Recently Beaton Capital has advised four private company sales where experienced buyers, keen to close a deal differed by over 50% of the final price – how can this be so, and what does it mean for a vendor?
Firstly, a vendor needs a valuation benchmark based on thorough market research of comparable and relevant transactions. This research should unpack the various valuation rationales so they can be made comparable at a granular level, this also assists in the transaction process by identifying where value is recognized by buyers – this is often different to what a vendor expects. The research will generate a range of multiples that are applied to the EBIT. It is human nature for vendors to be looking to make the multiple higher, and for the acquirers to restrict the multiple. Or put another way, the vendor is thinking from the point of view of value, whereas the acquirer is thinking price. There is a rouge element here that I am avoiding in this post, and that is the potential for a difference between a vendor’s expectation and the valuation benchmark.
Next, is the establishment of a sustainable EBIT, an EBIT that can be confidently expected to be maintained for the foreseeable future. This is where many vendors get carried away and adopt aggressive growth rates, which is unnecessary because most acquirers are seeking steady and modest growth rates. But key here is predictability, and how can you as a vendor convince an acquirer of the veracity of your projections. That, among other factors, will be a function of the market in which you operate, your business model and track record.
All these preparations at the start of the transaction process are critical for managing the expectations both of the vendor and the acquirers. Once the strategic fit discussions with acquirers have qualified the opportunity in their eyes, the early value vs. price negotiations can then be focused on two things – the multiple and the sustainable EBIT. And of course this is where the variation in valuation vs. price paid occurs.
Multiples – know your acquirer
In many transactions the vendor will have already identified the potential acquirer for the business. They may have existing working relationships with each other, or the vendor may have been approached already by an interested principal. But there is an old saying ‘familiarity breeds contempt’ and without exception we have found that the complacency of an existing relationship can have a negative impact on the willingness to pay at the high end of a valuation range. Vendors believe familiarity will identify value, which is logical, but it cannot be relied upon to be true. Familiarity may lock a potential acquirer into the past and prevent them from understanding the true potential of a business – we have witnessed this first hand. So vendors cannot rely just on a familiar cohort of potential acquirers, the market must be tested by approaching others that do not have a relationship with the vendor’s company.
Another behavioural constraint we witnessed was when a negotiator for an acquirer (a public company) openly stated that his company had been acquired for a multiple of 4, and so he would pay no more than this, regardless. We negotiated a multiple of over 6 with another acquirer for the same business.
The risk here for vendors that embark on DIY transactions or use inexperienced advisors, is that they will accept a significantly lower price. In the example above, a party that had a long history with our client offered $20m, but through our research and networks we identified a company that was very keen to enter a new market and paid $33m. We have many similar examples like this.
Sustainable EBIT – be believable
Will an acquirer accept your proposed EBIT forecasts? Maybe, but the way a vendor and its advisor presents this and backs it up will be critical. Again we have found that acquirers that are familiar with a potential acquisition company will be much harder to convince if the vendor applies an aggressive financial forecast. Better to be modest with the forecast and argue up the multiple. However, the reality of a sale is that an acquirer will anchor the price on the most recent financial year’s results. Few will use the forecast or average out the past trends in determining the price paid, but the history and forecasts will be used as ‘sanity checks’ and pointers for the due diligence and grist in the negotiations.
So the message here is to pick the right financial year in which to close the transaction, not a year following a dip or even dipping itself. Best to sell on the up, and leave a bit on the table to help you through the earn-out.
In our negotiations with acquirers we have found quite a wide range of scepticism, this is usually driven by their own histories of doing transactions. If they have had a bad run where their acquisitions have under performed post-acquisition, they are tougher on accepting a sustainable profit figure, and will discount it. If they have bought well in the past, then as you’d expect negotiations have been easier. But it all comes through in the final offers, and when you combine a discounted sustainable EBIT with a lower multiple it all adds up, and the gap between valuation and price widens.
Research, research, research
When we start a transaction we undertake considerable research to understand which potential acquirers are hungry and why. We also dig deep to understand the value proposition for an acquirer, their history of transactions, what they have paid, the terms they have offered and how their acquisitions have performed. We also investigate with whom we will be negotiating – at the individual level. Tensioning a sale process, by having more than one bidder, may not be enough to get the best possible price if all the parties in the ring have low pricing expectations.
The reality is that most vendors do not have the time to do this research thoroughly or manage the process effectively since they are running the business, and few advisors do it well since most are generalists, and as a consequence leave value on the table.
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Other related blogs and thought leadership from Beaton Capital can be found here:
- Selling the firm – does size matter?
- How much is my firm worth?
- 20 questions to test your resolve: do you really want to sell your firm?
- Earn outs: not worth the paper they are written on?
- Succession: trade sales – gain, pain, both?
- Takeaways from a recent sell mandate – points to consider when it comes to selling your firm
This post was written by Warren Riddell, of Beaton Capital and Beaton Research + Consulting. Warren’s details can be found at LinkedIn.
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