Hype. Is there anything more common on the Internet? Especially when it comes to entrepreneurs striking it rich when they sell their businesses. Headlines such as: “How To Sell Your Business For A Million Dollars!” and “How To Sell Your Business For More Than It Is Worth” are common. And perhaps that is to be expected when you consider newsworthy deals such as Facebook’s recent purchase of WhatsApp for $19 billion.
Unfortunately, the conditions that justify that kind of valuation don’t exist in 99.99% of small businesses. Still, these sorts of news-making deals color our perceptions about how much a business (even a very small business) is worth.
But when owners think about how much their business might sell for, the most overlooked question is this: “What type of buyer will my business attract?”
If you dominate a niche that Google wants a part of, or you’ve created a piece of proprietary software that Facebook wants to own, then you are on your way to easy street. But what about the rest of us?
The reality is that different sized companies attract different types of buyers. And those buyers all have different goals and financial capabilities. To understand how your business will be valued you first must understand what type of buyer your business will attract.
Here are the 4 types of business buyers:-
#1. Professional Investors
These are venture capitalists and private equity groups. They may have an intermediary approach them about a company that is already on the market. But more often than not they proactively seek out companies that they believe have good management in place and have the potential for fast growth.
Most investment groups stick to just one or two industries that they know well and have had success with. Since they are experienced in buying similar companies these investors have a ready-made formula to value/price a business. After analyzing your business they may make you an offer based on that formula.
These professional buyers are investors not managers. They will value your business based on the assumption that you will stick around to run things once they inject the operation with their cash. So if you are looking to retire this is probably not going to be an option for you.
But if the only thing preventing your company from growing quickly and massively is the cash, this type of investor may be what you are looking for. And they may already be looking for you.
#2 Industry Buyers/Larger Competitors
While the Professional Investor is interested in a several different industries, the Industry Buyer is only interested in companies that are similar to the ones they already own. The Industry Buyer pursues a growth-through-acquisition strategy. Acquiring smaller competitors allows the Industry Buyer to expand into new regions much faster than if they tried to grow organically.
This strategy may also create economies of scale. By acquiring many new customers at once, a business can buy raw materials in larger quantities and increase production thereby lowering their per-unit cost. They may also be able to lower overhead by eliminating redundancies that exist. Most often this means pink slips for the smaller company’s management team because the buyer already has their management team in place.
Faster growth, economies of scale and reduced overhead mean that there are incentives for the buyer to pay a premium for any business that can provide these benefits.
It is typical for the acquiring company to be 5-10 times larger than the business that they buy. So if you are approached by a competitor that is about your same size don’t expect a favorable offer. In fact it is a good idea to consider direct competitors or your peers the buyer-of-last resort. Usually they just want to see if you will bite on a low-ball offer. Or worse, they may just be trying to learn the secrets of your inner-workings. But regardless of their motivations, they won’t have the financial resources to make you an above average offer.
#3. Strategic Buyers
Strategic buyers are the media darlings of the business acquisition world. Think of the aforementioned Facebook acquisition of WhatsApp. Or Google’s acquisition of YouTube. (Not to mention their acquisitions of Android, Motorola, Zagats and so on).
Strategic Buyers are looking to immediately acquire assets that only the target company can offer. Most often that means patented technologies or proprietary content. Things the acquiring company can’t easily go out and create for themselves. The defining feature of these newsworthy deals is that the acquirer’s valuation has little or nothing to do with the sales and profits of the target company. Google valued YouTube based on what it could produce once it was part of Google’s family of properties. These are the rarest of situations but the most often talked about in the media.
Why High Valuation Multiples Are Justified
One thing all three of these buyers have in common is that they are looking for very specific types of businesses that meet their very specific set of criteria. They may look at hundreds of candidates in order to complete one acquisition.
And the other thing that can’t be overlooked – the acquiring company is more motivated to buy than the target company is motivated to sell. More often than not, it is the acquiring company that initiates the discussion. This is a major factor that can drive the selling price skyward.
Patented products, proprietary software, economies of scale, experienced management teams and operating systems already in place are some of the features that can make a company an attractive acquisition target. Add in the potential to quickly increase margins and dramatically increase market share and you have a pretty potent list of motivators for the acquiring company.
It is common for Industry-Buyers and Professional-Investors to pay 5 to 10 times a company’s annual earnings when making an acquisition. And when Google makes a strategic acquisition there is almost no limit to what they are willing to pay. They will value the company based on their projections of what is can produce once it is part of their stable of products and services.
#4. The Fourth Type Of Buyer – The Individual
But the reality is that few businesses will ever become a target for professional buyers. Most small businesses are owned by an individual and will be bought by another individual.
And that means that the new owner will run the business much like the current owner has. Few if any of the factors that motivate professional and strategic buyers apply.
For example:
- There are almost never any patents or proprietary information involved
- The Individual Buyer is typically a first-time owner and therefore won’t have the ability to exploit economies of scale, reduced redundancies or geographic expansion.
- The Individual Buyer usually finds businesses that are already advertised for sale. They don’t approach an owner unsolicited and try to motivate that owner to sell. The seller is usually more motivated than the buyer.
So instead of valuing these businesses on potential the buyer will value them based on their historic profits. And historically, when one individual sells his or her business to another individual we see selling prices around 2-3 times those annual profits.
Conclusion
Not all businesses are valued the same way. And the first step toward understanding the value of your business is to understand what type of buyer your business will attract.
Images: “Business hand shake with machinery background/Shutterstock.com“
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