5 factors that can affect business valuation

When you begin thinking about selling your company, among the first questions you’re likely to ask are, “what is it worth?” and “who can help me assess valuation and marketability?”

The answer can often be elusive and depends on a variety of factors that might not be evident to owner operators who lack experience in structuring and financing acquisitions. “There are a lot of misconceptions about business valuation. This is due, in part to the myriad of ways in which businesses are valued,” says Kevin Groff, senior vice president of Business Owner Advisory Services from U.S. Bank Wealth Management.

Among the reasons for undergoing a valuation are insurance buy-sell coverage, to obtain banking collateral and as part of the estate planning process. “Transactional value is what willing buyers are likely to pay in an open market transaction,” says Groff. “The price depends on the nuance of what a business or its assets are worth to specific investors at a moment in time.”

The reality is that many factors influence the perceived value of private companies positioned for sale. These include:

• The current state of the mergers & acquisition (M&A) market and the cost of capital.
• Industry trends and how well the target company is positioned to benefit from them.
• The likely target market (i.e., types of buyers such as private equity firms, industry consolidators and large strategic buyers).
• “The story” supporting the company’s continued (or renewed) growth and profitability.
• The ability to address and reduce the risks that could hinder “the story.”

“Buyers will review all of these areas and more to assess the value of the business and identify any additional investment that may be required to grow the company,” says Mike McCoy, senior vice president and managing director of Business Owner Advisory Services from U.S. Bank Wealth Management.

1. The state of the M&A market

As in other aspects of life and business, timing is a factor that is not completely in your control, but one that can make a significant difference. “When the M&A market is hot, as was the case in 2021, it’s a prime time to be a seller,” says McCoy.

“When you’re in this kind of market, there tend to be more buyers looking for acquisitions than there is inventory of companies for sale,” he adds. “We usually see more competition among buyers and more capital available to fund acquisitions at premium valuations.”

Yet some sellers make the mistake of waiting too long to put their businesses up for sale. They may be looking to execute certain growth and operating initiatives before starting discussions with buyers. “If the company is performing well, waiting too long can be a mistake,” says McCoy. He warns that the industry in which a company operates, the broader economy or M&A and capital markets could soften at some point. “It’s best to sell good performance and a solid growth plan into a strong market,” says McCoy.

2. The appeal of your industry and your business within it

A comparable consideration to the broader economic environment is the current appeal of the industry in which your business operates. Does your company serve a market that is growing or shrinking? Regardless, how is your company performing relative to its industry or peer group?

Investors may pay a premium for companies that outpace their comparable firms even in challenged industries. Outperforming them in a growth market is even better. The underlying concept is that organic growth for many is difficult and expensive. Buying a business to harness its success can result in a much more predictable return on investment for the acquirer.

“Being in the market at a time when your business is demonstrating strong growth and profitability will make you stand out, especially if your business is performing better than industry benchmarks” says McCoy.

3. Where the buyers are

One key to a successful transaction is identifying the most appropriate buyer for the opportunity. A starting point is to determine what you’d like to achieve as a result of the sale. While many may assume that the top priority is receiving the highest possible sale price for the business, that isn’t always the case.

Perhaps you want a buyer that will provide a high degree of support for the next tier of management to help continue to produce strong results. Maybe you want to maintain continuity of business leadership within a family or among current key employees. Your priorities can often help guide you to the right kind of buyer.

McCoy identifies three primary types of buyers in the market.

• Strategic. “These are larger companies in your industry who see revenue and efficiency opportunities that can be achieved through an acquisition and integration,” he says.
• Private equity. According to McCoy, “These financial buyers tend to be more focused on the quality and sustainability of earnings as a platform, along with sophisticated growth strategies. Private equity firms seek both new platform investments, as well as add-ons to existing platforms.”
• Family office. “Family offices have become meaningful buyers in private transactions,” says McCoy. “They’re looking for sustainable cash flows with reasonable growth.” Family offices typically fund acquisitions utilizing more equity and less debt. They’ll consider both controlling and minority positions in private companies, invest for long duration hold periods and are not actively involved in operations.

It can be beneficial to match your own objectives to the pool of potential buyers in the market. It isn’t unusual to explore all three types of buyers to seek out competitive offers for the business.

Another factor to keep in mind is that those who are considering buying your business will likely have a better understanding of how the process works. Most acquirers have experience in the process, while sellers typically have not been in this position before or only rarely. A sell-side M&A advisor can provide effective management of the sale process with the right suite of buyers, creating significant negotiating leverage for the seller.

4. The importance of “the story”

Marketing is part of the process of selling a business. In other words, it helps to undertake a process of “crafting a story” that can help define the business and its value to prospective buyers.

According to Groff, a key question to ask is, why should this buyer invest? “It’s much more effective to answer the questions before they’re asked,” says Groff. “Working with professionals experienced in similar transactions can help sellers anticipate the critical questions likely to be the focus of potential buyers and then be in a position to prepare the best possible responses.” Experienced sell-side advisors will help distill a narrative that explains the business and the attributes that create and sustain value.

In addition, telling “the story” of the company is a way to showcase the company’s strengths and potentially offer strategies to weaknesses that might not be addressable before a sale. These focus areas typically include:

• The quality and depth of the management team
• Factors that differentiate or shield the company from its competitors
• Facilities and equipment
• Scalability of operations
• Product lines and pricing strategies
• “Stickiness” or continuity of its customer base
• Clarity and visibility of operating margins
• Future growth initiatives

An underlying question from private equity investors is whether the target is a “big small company” or a one that is capable of transforming into a “small but growing company.” The difference is often in the architecture that underlies the issues that have been raised here.

5. Reduce risk for the buyers

Proving that your business holds a value that you think is appropriate has a lot to do with minimizing factors that create a perception of risk to buyers. “The inverse of value creation is risk and erosion,” says Groff. “Assume that experienced buyers have seen things go poorly in the past. Companies that have plans in place to mitigate threats to performance and cash flow are worth more in the marketplace.”

Among the issues that can potentially detract from the market value of a business are:

• A retirement plan that leaves a knowledge, skill or retention gap to the new owner. It’s very difficult to replace an owner who has not groomed somebody to take their place.
• Failure to develop a “strong bench” of talent that “owns” core functions like finance, accounting, operations and sales. This gap creates expensive holes that buyers may need to fill.
• Insufficient investment in facilities, equipment and product development.
• Compliance or legal issues that could create exposure for the new owner after closing.
• Incomplete or inconsistent books and records that make it difficult to validate past performance.

Groff points out that the easiest way to think about these issues is to view the transaction as an investor or bring in an advisor who can provide that perspective. “Current owners are more knowledgeable than anyone about what keeps them up at night. Assume that an experienced acquirer has the same information,” says Groff.

McCoy adds, “It helps to avoid surprises and share information with potential buyers at the right time.” For example, working with outside accountants to provide financial schedules with thoughtful normalization adjustments can be extremely beneficial in the due diligence process.

In addition, showing sales and growth projections that are in line with the business’s recent history is valuable. McCoy says this can add credibility as you seek to reach agreement on a purchase price with a potential buyer. He emphasizes the importance of ensuring that the business performs in line with the projections through the entire sales process.

Planning and professional help makes a difference

Most business owners are well versed in managing the day-to-day needs of their company. Few have experience in handling the sale of a business. “Too many business owners put too little thought into what it takes to prepare, market and close a transaction,” says Groff. In a market that can be as dynamic as middle market M&A, it’s important to have a guide with an updated road map to current themes, structures and valuations.

Owners should always be prepared to sell – even if it’s not their current goal. Planning can instill an importance to the factors discussed above. A business with less risk and a brighter upside is more attractive to outside buyers as well as a more attractive asset that can potentially be passed on to the next generation.

Groff and McCoy recommend that business owners plan for the day when an exit might be the best option. Thinking and planning through what’s needed along with working with advisors in advance can put you in the best position to initiate and actively pursue the sales process.

Considering transitioning your business? Learn how Business Owner Advisory Services from U.S. Bank Wealth Management can be your strategic partner to help drive action.