business buyer

One of the most common challenges in mergers and acquisitions is getting a seller to understand the transaction from the perspective of the business buyer. Sellers may spend 20 or more years building their business and likely understand every detail of how to make their business successful. However, it may be difficult for a seller to understand “value” from a potential buyer’s perspective. It’s important that sellers work with an experienced M&A professional to understand this perspective and have realistic expectations for the value of their company.

Sellers need to understand that fundamentally, any price (stock price, business value, etc.) is a function of two things: (1) expected future cash flows and (2) the discount rate. In each M&A transaction, each buyer is trying to estimate his or her expected future cash flows and is trying to assess what might be a proper discount rate. As sellers better understand how these two items relate to their business, he or she can better establish realistic expectations for the value of their business.

Expected Future Cash Flows

An important first step in establishing realistic expectations is for the seller to understand a potential business buyer’s expected future cash flows. There are many factors that influence the buyer’s expected future cash flows and below I list four simple questions that serve as starting point for understanding them.

  1. What are the company’s current cash flows and are they sustainable? An informed buyer analyzes company financial statements and distills performance to an established trend of cash flows and then assesses the sustainability of these cash flows.
  2. What is a reasonable salary for a replacement manager? Whether the buyer plans to operate the company or pay someone else to do so, he or she will consider a replacement manager’s salary in estimating his or her expected future cash flows.
  3. What are the likely short-term and long-term capital expenditures? Each company requires fixed assets to operate successfully and those assets eventually need replaced. A buyer will consider these costs when making a purchase decision.
  4. What are the likely working capital investments? A buyer will consider necessary initial cash investments when making a purchase decision.

The Discount Rate

Another important factor for sellers to understand is the buyer’s discount rate. The discount rate captures the riskiness of the investment relative to other opportunities or investments. The discount rate applied to an M&A transaction is likely higher than most sellers expect.

Generally, a reasonable (pre-tax) discount rate will be between 20% (low risk) and 30% (high risk) for most M&A transactions. A particularly risky company may exceed a 30% discount rate and an extraordinarily stable company may fall below 20%, but this range is generally observed in the market. The range is quite large and a 10% difference can greatly affect the value of a business. There are several factors that increase risk and therefore the discount rate assigned to an M&A transaction. But there are also steps an informed seller can make in order to mitigate the perceived risk.

First, there is significant risk that business performance may suffer with the departure of the current owner. A business buyer may be concerned that business relationships and processes hinge on the person (owner) rather than the company. A savvy owner can mitigate this risk by “working herself or himself out of job” prior to taking the company to the market. This may mean shifting essential tasks to others within the organization or building business relationships with an exit strategy in mind. At a minimum, sellers should have a plan to directly address this concern among potential buyers.

Second, buyers are cautious if a business relies too heavily on a few clients or idiosyncratic demand for goods and services. To the extent a company can demonstrate a diversified customer base or a strong repeat-customer base, the perception of this risk can be greatly reduced. Buyers will want to understand the customer-generating process so sellers should be able to explain how a buyer can jump in and be successful in that process.

Finally, the business buyer will be concerned about a company’s exposure to micro and macro-economic factors. Both the local economy and industry trends will be a focus for any potential buyer, especially a buyer unfamiliar with the locality or industry. In recent years, buyers are more often asking about the robustness of companies and whether they can survive during downturns. Sellers may have more trouble mitigating this risk, but sellers should have a plan for how to discuss these risks in the selling process.

A Simple Example

Let’s sell a hypothetical company.

  • Assume the company has $1.5M in current cash flows. A buyer may perceive that current cash flows are not sustainable, but for this example, we will assume that they are sustainable.
  • The buyer would make adjustments such as (example amounts):
    • Paying a replacement CEO ($150,000 per year)
    • Annualized capital expenditures ($150,000 per year)
    • Initial Working Capital investment ($75,000)

With just these simple adjustments, the buyer’s expected future cash flows are likely around $1.2M with an initial cash investment of $75,000. If the company has “average” risk, most buyers would use a 25% discount rate for the transaction. $1.2M in sustainable future cash flows and a 25% discount rate yields a value of $4.8M. The buyer will likely then make an adjustment for its anticipated working capital investment, yielding a net offer price of around $4.7M.

Moving Forward

If you are a seller and are considering an exit strategy, it’s important to work with a professional M&A advisor to understand your specific company. While I provide a simple example and some basic pointers, each M&A transaction is much more complicated and requires careful analysis. However, I hope this short article provides sellers some valuable insight from a potential buyer’s perspective.

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