Thinking About Selling Your Business? 4 Considerations.
It has been a tough couple of years for many business owners seeking to sell. Struggling with tepid or flat sales growth while confronting low inflation and the desire to increase wages, the window of opportunity was barely cracked open.
But the outlook for business owners is improving. Unemployment is low, consumer confidence and exports are up, and the U.S. quarterly GDP is at its highest growth rate in two years. With this backdrop, the recent Fed interest rate increase and talk of lower corporate tax rates might be the catalysts to spark accelerated M&A activity.
The buyers are ready. Private equity investors targeting the lower middle market are flush with equity. Corporate balance sheet liquidity is at historically high levels. Among bank and non-bank debt providers, all are clamoring for quality deal flow. The window of opportunity appears to be opening and savvy entrepreneurs will be prepared to take advantage of the opportunity.
Following are four considerations business owners should weigh:
1. Sell into the peak: Buyers’ expectations about the future drive business valuations. Too often sellers wait to enter a bull market, believing they need to have one to three years of historical sales and EBITDA (earnings before interest, tax, depreciation and amortization) growth to command a premium price. Upon arrival, they find buyers and lenders are discounting the future, fearful that the economy is cycling into the next downturn. It is critical that an acquired business performs well in the first two years following its acquisition. Lenders, institutional investors, and shareholders evaluate private equity partners and corporate managers based upon post-close, deal performance. These investors are more confident if macro-economic trends are pointing up. Like public company share prices, the value of private businesses rise and fall based upon future expectations.
2. Dissect the top-line: Whether selling 20% revenue growth or asserting the recent revenue decline was an aberration in an otherwise upward trend, successful sellers provide documented insight that creates confidence regarding future business prospects. Historical results are a key proxy for estimating the future. A detailed analysis of revenues and unit volume metrics by marketing channels, products, major customers, salespeople, or geography provides clarity that facilitates focus. If an owner can instill confidence and sell prospective buyers on the potential of each incremental increase, the magic of compounding will take care of the rest. In our experience, this is the most common shortcoming of privately-owned businesses. The data exists, and we often assist our clients by mining the data for its predictive insights while selling the business. A pre-sale engagement focused on sales analysis will have a very high ROI and provide time to organizationally internalize these sharpened insights.
3. Deal structure maximizes total value: When it comes to deal structure, there are generally three types of consideration: (1) cash, (2) sum-certain obligations, such as seller financing, and (3) contingent considerations, such as sales royalties, earn-out payments, or retained equity ownership. All-cash deals are the exception, not the norm, and, we would argue in most cases all-cash sellers have left money on the table. Private equity investors tap three basic pools of capital to fund their purchases: senior bank debt, subordinated debt, and equity. Each pool has different underwriting requirements, but they are all constrained by two common financial governors: asset coverage and rate of return. For established, lower middle market enterprises, these constraints tend to be measured against historical performance in soft markets, whereas in stronger, optimistic markets the focus is more on future performance. As valuations eclipse 5X EBITDA, an investor’s ability to deliver incremental cash diminishes exponentially and eventually reaches zero. Somewhere along the tail of this curve an opportunity exists for sellers to capture more value by holding a subordinated note or accepting contingent consideration. An art of deal making is crafting total consideration to maximize the potential payoff in the context of the outlook for the business, and the seller’s lifestyle and financial goals.
4. Pursue public companies first: Private equity investors are designed for speed and once contacted they will swarm a deal, forcing the seller towards a structured auction process where exclusivity is often negotiated. Deliberations inside corporate buyers are more complex and usually slower to develop. Houlihan Capital typically bifurcates the process by approaching corporate buyers first. In recent years, a majority of our clients have been purchased by corporate acquirers. For many public companies, revenue growth is challenging and acquisitions enable public company managers to increase revenues and expand capabilities. Public companies have more capital available at a lower cost, so they have the capacity to offer more cash at close. Further, with stock prices at historic valuations, public companies realize a tremendous value arbitrage even on fully-priced, private market deals. They are surprisingly receptive to structuring contingent consideration on top of what otherwise might be termed a fully-priced deal. However, there are two caveats: First, the target generally needs to boost the acquiring entity’s top or bottom-line by 20%. The deal must have a material impact. Second, the chance of success for a target business is increased if the target broadens the acquirer’s capabilities with new products, distribution channels, or cost-efficient operating methodologies. They see much less value in “buying” volume.
For business owners exploring a transaction, we encourage you to start thinking about both your personal and business goals and motivations long before the execution phase. Houlihan Capital provides boutique investment banking services to lower middle market companies and has extensive experience working with business owners across many industries.
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