by Gary A. Plaster and Erich Bergen
Baker Tilly Virchow Krausse, LLP is an IMA Member
As the baby boomer population ages, more business owners will be looking for an exit in the next few years. According to research conducted by Baker Tilly Virchow Krause, LLP (Baker Tilly) and Baker Tilly International, family businesses valuing trillions of dollars will change hands over the next few years as baby boomers leave management.
Unfortunately, many of these family-business owners will be surprised and disappointed in the actual market value of their businesses. That is why it is imperative for sellers to understand how potential buyers value the business – we call that the “outside-in” perspective – and implement the necessary steps to drive value.
Professor at Princeton University and behavioral economist, Daniel Kahneman, won a Nobel Prize for integrating psychological research with economic science. He suggested business leaders suffer from an overconfidence bias and need to integrate an “outside-in” perspective to improve business decision making. To that end, we believe family business owners need to put themselves in the shoes of potential buyers.
A buyer is willing to pay a premium based on their perception of risk and return. If the characteristics a buyer values – those that both reduce risk and improve return – are present, a buyer will pay top dollar. Those characteristics are called value drivers. Value drivers are characteristics of a business that either reduce the risk associated with owning a business or enhance the prospect that the business will grow significantly in the future. It is up to the seller to understand what drives the value of their business.
Some family-business owners decide not to sell their business immediately because they cannot get the market price, and subsequently the net after-tax proceeds, to achieve a target liquidity goal. In those situations it is incumbent upon the owners to develop a plan to increase the value of the business by levering the value drivers important to potential future buyers.
Risk reduction value drivers
In the eyes of the buyer risk reduction value drivers improve the likelihood of a successful acquisition by eliminating major risk factors that could erode value post-acquisition. The risk reduction value drivers are:
- Recurring revenue streams. Contractually recurring revenue reduces risk and increase return for the buyer. It also produces predictable and forecastable cash flows and reduces the surprise factor post-close. Examples may include annual contracts for maintenance, licensing, subscriptions and other annuitized fees.
- Stable, predictable and growing cash flow. Buyers pay for cash flow that increase over time. Typically, buyers buy companies that are growing and have a track record of growth in EBITDA and revenue.
- Diverse & sticky customer base. Red flags go up with potential buyers when any given customer accounts for more than 10 percent of sales. Buyers like to see many loyal customers with built-in high switching costs.
- Diversified and/or proprietary products or services. The market rewards innovation and punishes commodity businesses. Proprietary and/or diversified products create barriers to entry and reduce competitive market risk.
- Robust operating systems and procedures. The company must be able to operate after the seller leaves. Operating systems and processes must be documented and functioning.
- Reliable financial information and controls. The lack of financial integrity is the most common hurdle in the sales process. Buyers require financial statements audited/reviewed by a reputable CPA firm.
- Stable and available workforce. A high quality, stable workforce increases value and reduces risk. Availability of talent in the marketplace will support future growth.
- Loyal and motivated management team. The company cannot be dependent upon the owner. Buyers want a high quality team that will stay in place and continue operating the company.
- Diversified supplier base. Dependency on key suppliers could create risk related to capacity, quality, financial viability, catastrophe, global trends and market disruption.
Growth value drivers
Growth value drivers are more strategic in nature and will impact future growth. Remember, buyers purchase on companies with the objective of continued future growth. The growth value drivers are:
- Realistic & documented growth strategy & vision. Buyers will pay a premium for a thoughtful, well-crafted growth strategy. The strategy provides an opportunity for the seller to discuss the value of future opportunities and the vision for the future.
- Sustainable competitive advantage and barriers to entry. Competitive advantage is the reason your customers buy from you and not the competition. Buyers will pay a premium for companies with a distinct competitive advantage.
- Scalable operating systems, processes and business model. Buyers value business models with the potential for non-linear growth (i.e., those companies that do not require increased input to achieve increased output). The profit margins of scalable businesses increase with revenue because costs do not rise in lockstep with increasing revenue.
- Targeting and domination of growing market segments. Buyers pay a premium for companies that operate in and can dominate growing markets.
- Unique fulfillment of unmet customer needs. Companies that fulfill otherwise unmet customer needs and create differentiated customer value command higher profit margins and subsequently higher valuations.
In summary, many owners of family businesses will be looking to sell their companies in the next few years. In order to achieve target liquidity goals, sellers must understand how potential buyers view their businesses. They must take an “outside-in” perspective. Sellers must understand what drives value from the buyer’s point of view and create plans to reduce risk and grow value.
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