I want to cover an important M&A subject—valuation expectations between buyers and sellers.
Valuation is essential because it gives buyers an idea of how much they should pay to purchase a business and sellers how much they should sell for.
Seems simple, right?
But like everything we humans do – we overcomplicate the hell out of it.
Why does this happen?
It often stems from differences in perspectives, goals, information or how we interpret external factors.
Keeping it Real
As a sell-side intermediary, you deal with both sides of a transaction. Yes, you are engaged by the seller, but if you don’t make things work for the buyer, the deal will fall apart.
In my experience, buyers have a more realistic view of valuation based on a simple formula.
Risk vs return.
The returns from the business have to make sense for buyers to invest. Enough cash flow to cover the debt (borrowed against the assets), the owners’/manager’s salary, and pay for the business’s operating costs.
In my experience, most sellers don’t clear all these hurdles from a pure cash-in vs. cash-out standpoint.
You can put in adjusted EBITDA and a long list of add-backs. But buying businesses comes down to cash flows. If the cash flows don’t match the valuation, the deal is toast, and the transaction cannot be financed.
So what are the factors that contribute to buyer/seller misalignment? Summarized below are some straightforward answers:
Sellers often don’t understand how bank financing affects their sale price.
Sellers we meet have an inflated perspective of their business’s value. Unless there is a super compelling reason to buy the business, acquirers are unwilling to stretch the valuation due to perceived risks regarding the company’s stability going forward.
Combine this with a higher cost of debt yields and you will get a lower valuation.
Access to financing from credit providers is getting harder. With interest rate rises it decreases the amount of debt lenders are willing to underwrite.
This means less cash at close for the seller.
Success in the past vs. perception of the future and the investment needs to grow.
Buyers often question the reliability of future earnings even when sellers present a strong case. Buyers base value only on historical performance, while sellers naturally want credit for what has already been built and what could be fulfilled in the future.
Much of the gap is driven by misinformation around multiples. In prior years where economic growth and access to capital flowed much easier buyers paid higher multiples. This has now become a rumor that still circulates in sellers’ minds.
Most sellers don’t understand the underlying factors that drive multiples. They only hear numbers like “3,4,6, 10x.” Every business has a downside, and there is always a certain amount of risk involved in owning one.
You must follow business investment cycles.
A major factor at play is the duration of investment cycles.
Sellers usually reinvest their earnings through the growth phase of their business. They may not have seen a full return.
Buyers pay for assets. The earnings are a by-product of how well the company uses those assets
If earnings have a greater value than the assets on the balance sheet you own a sellable business.
Your business model works and provides a benefit stream to the owner.
Breaking the Divide
So how can we break the divide? Here are some thoughts.
Sellers
Buyers
Your returns must be attractive against the risks of running the business
Buyers need to be comfortable with risks (they will always be there).
Your balance sheet needs to pass the test for banks and financiers (not buyers).
You need a deposit and access to capital to buy businesses. If you don’t have the funds, the deal will collapse quickly.
Forecasts need to be built on consistent data points and validated with contracts.
Go through the data points and rationale. Consider the past and be positive about the future. Otherwise, why are you even bothering?
Know where you are in your company’s investment cycle before you transact.
Invest before the next wave of growth. That’s where the returns are captured.
In the end, transactions are about finding alignment and having the courage to make it work. Finding the middle ground. If someone is winning it means the other person is losing which is far from ideal deal-making.
Finding the right buyer is the hardest part of selling. You need help.
AcquisitionHub uses a targeted approach to find and recommend buyers.
We do the work!