Know Your Buyer

Know Your Buyer

When preparing to sell your business there are a few steps you need to take to ensure you are getting the best price for your company. To get an overview of these steps check out our blog post “5 Steps for Managing an Unsolicited Offer.” Knowing your buyer is step two and critical in determining your company’s value in the marketplace. Understanding the types of buyers, what their motivations are and what they are willing to pay will help you get a better grasp of your company’s worth. Below we detail the five main categories of buyer types and the methods typically used for valuations by each.

1. Strategic Buyers are normally large companies in the industry (or in a complimentary industry) that want to combine the two companies to create efficiencies. These buyers are forward looking and mostly concerned with how your company can benefit them in the future.

Likely these companies will use the discounted cash flow approach to value your business, which is based on future earnings. The discounted cash flow takes reasonable projections (usually 5 years), and uses a discount rate (usually the cap rate plus rate of growth) to calculate the present value of the future cash flows.

With their ability to take advantage of synergies, Strategics are often willing and able to pay more for a company than other buyers. So, if your company is poised to grow over the next few years, selling to a Strategic Buyer might be your best bet to obtaining the maximum amount for your business.

A word of caution: due to the nature of selling to a competitor or other industry-insider, confidentiality is paramount. Customer lists, key employees, trade secrets, etc. should all be protected throughout the transaction process. In selling to a strategic, companies must walk the fine line of providing enough information to get the buyer comfortable while safeguarding against providing too much information which may give the strategic buyer a competitive advantage in the event the transaction fails to materialize.

2. Financial Buyers are typically private equity firms, venture capital firms, hedge funds, family investment offices or high net worth individuals. These buyers are primarily interested in a return on investment. While your company’s opportunities for growth are important to these buyers, your past performance plays the major role when they evaluate your company.

A financial buyer’s valuation methods will probably be based on multiples of earnings (using EBIT and EBITDA). This valuation approach is used as a benchmark to evaluate your company against some comparable (i.e.: a public company multiple or a transaction multiple).

While financial buyers are known to lead to lower multiples there are many reasons you should considering selling to them. First, most employees, including management, will likely keep their jobs. Second, by avoiding a strategic buyer negotiation, the transaction can often be less invasive, more confidential and less threatening to existing operations. Third, many larger financial buyers will ask business owners to retain a portion of the equity: a sign that the sellers are optimistic, and a chance for sellers to get a “second bite at the apple.”

A word of caution: financial buyers take on many shapes and forms. When dealing with smaller and individual financial buyers, ensure that the buyer has the financial wherewithal to consummate the transaction. To many sellers, a “search fund” and “fundless sponsor” will look just like a fully funded financial buyer; however, these groups often negotiate a deal with the seller prior to securing the funding to consummate the transaction.

3. A Lifestyle Buyer is someone, usually an individual or small team, who wants to purchase a company that will help them sustain a particular lifestyle. These buyers have already created sufficient wealth from other jobs and companies, which now allows them to focus on purchasing businesses that are more aligned with their personal life and goals. Lifestyle buyers look for companies with limited scalability and growth.

The preferred valuation method for these buyers uses a multiple of seller discretionary earnings. This method establishes the business value by calculating the total cash flow of the owner (including salary, benefits, depreciation) and adding it to the profit of the business to get total cash flow.

These buyers are not likely to pay for any future earnings or growth. Accordingly, companies that have hit a growth plateau and can easily be run by a sole proprietor are a perfect fit for a lifestyle buyer, as long as the company can provide sufficient to funds to cover all operating expenses and a livable wage.

A word of caution: transitioning executives often fill the ranks of Lifestyle Buyers. Do not confuse success in the corporate world for success in entrepreneurship. As a whole, these buyers are risk averse. This risk aversion will be reflected in the purchase price (an unwillingness to pay for potential future value) and the structure (an unwillingness to put down large sums of cash). Sellers often carry (in the form of seller financing) a significant portion of the transaction for the Lifestyle Buyer.

4. An Industry Buyer is a company that acquires another business from the same industry, typically for expansion purposes. They differ from a Strategic Buyer, because an Industry Buyer is usually somebody in your niche that considers your company inferior to theirs and is only interested in obtaining your assets.

The usual valuation method used by this buyer is the asset approach, which uses the current value of a company’s tangible net assets as the key determinant of fair market value.

If your company has an attractive client base, technological advancement or geographic coverage that is perceived as valuable, an Industry Buyer may try to purchase you. But be wary, as this buyer is mainly concerned with your acquiring your assets. They tend to pay less than other buyers, only paying for the assets/business knowledge they need from you.

A word of caution: magnify the confidentiality concerns related to the Strategic Buyer ten-fold when dealing with Industry Buyers. Often-times, the “cons” of selling to an Industry Buyer outweigh the “pros”. Consider this transaction carefully and often as a last resort.

5. An Inside Buyer is someone currently involved with your company like management or key employees. These people know your business from the inside and may have a personal stake to ensure it continues to operate successfully. They may be willing to pay more for your company than an outside financial buyer would, because their inside knowledge lowers their risk; however, many inside buyers fail to make the risk adjustment required to transition from employee to owner.

A word of caution: company insiders frequently lack cash, while they may be willing to pay more, it’s rare that they can actually afford to pay more. In fact, you will likely be asked to finance a large part of the transaction yourself, or arrange third-party financing through a leveraged buy-out.

Keep in mind that each buyer is unique and may not stick to the valuation methods described above. Buyers can use a variety of different valuation approaches depending on their overall goal. It’s important to do research on your potential buyers and obtain an understanding of why they want to purchase your company. Knowing your buyer will help you identify what valuation method they might use and provide insight how much they will potentially offer to buy your business.