One of the primary pillars of a succession plan is understanding a company’s valuation. As someone who appraises businesses for a living, I can tell you there is no “one size fits all” formula to valuing a business. Each business has nuances relative to i) the industry in which it participates, ii) composition of experience and key management, and iii) financial profile and performance. As experienced in recent years, some businesses are more adaptable to changing socioeconomic events / challenges such as COVID, supply chain constraints, inflation, workforce turnover, and others. However, one element is true: Regardless of internal or changing economic conditions, valuations may vary based on the purpose or intent of the seller.
Purpose matters. Understanding the intent and purpose of the valuation can help frame where a valuation may fall in the spectrum of those multiples often heard from peers. We can’t cover them all, but the following are a few of purposes / situations that drive the valuations.
Intention I: Strategic Purchase / Private Equity
Strategic buyers and private equity investment account for the highest valuation multiples in the private market. In the case of the strategic buyer, the acquiring company has identified a principal reason or list of reasons why the acquisition of a certain business is attractive. In many cases, the strategic buyer has its own management resources, interrelated companies, or owns the target’s competitors in different markets. They can leverage their knowledge, infrastructure, and strategy through the growth of a newly acquired company with less risk. As a result, these types of buyers may be willing to part with more capital (i.e., higher valuations) to get a deal done for the right company.
Similarly, private equity funds have required investment targets to buy companies on behalf of investors. They provide strategic capital infusions that may be able to accelerate the growth of a potential target. Additionally, their investment holding period is traditionally five to seven years. As such, they often mitigate the risk of an acquisition by allocating part of the purchase price consideration (how the purchase price is paid) to rollover equity or a contingent payment to keep sellers invested in the well-being and prosperity of the company. In either consideration paid scenario, the dynamics of the business, its purchasing power, and management team are incentivized by the prospects under new ownership. Consequently, valuations are typically at the top of the range for any given company.
Intention II: Management / Employee Buy-Out
For all the reasons private equity and strategic buyers are customarily on the higher end of the valuation spectrum, the same reasons are why management or an employee buy-out is on the lower end of the valuation spectrum. Most importantly, existing management traditionally does not possess the capital to buy out existing owners in a single purchase or have significant market knowledge to effectuate the transaction. Management likely has not experienced operating a business as an owner which comes with its own set of challenges and is viewed as a risk to the lending community. When valuing a company being purchased by existing management, the recent historical performance is the strongest predictor of how the business will perform in the future (understanding there are one-time events and impacts such as covid which are accounted for accordingly). In many cases, management buyouts are also completed as stock vs. asset deals. The incoming owners buy the company and its assets “as is” vs. reaping the tax benefits of higher depreciation and amortization often accompanying an asset deal.
Compared to a transaction with strategic or private equity acquirers, it would not be uncommon to see a 25%-35% valuation discount.
Intention III: Keeping it in the Family
When the founding generation (“G1”) sells or transfers the business to the next generation (“G2”), discounting of a valuation becomes more imminent. The intentions of the seller are typically not to walk away with the highest value, but rather to keep the family business in the family. In this scenario, the marketability of an equity interest in the company for a non-family member is almost non-existent. As such, the valuation of a company is generally at the lower end of the range of multiples from a fair market value perspective.
Intention IV: Liquidation
Sometimes referred to as the “floor value,” the liquidation of the company’s assets regularly results in excluding the benefit of goodwill generated from the operating company. In a liquidation scenario, the retiring or exiting owner sells the business assets, customer lists, and similar assets at a discounted value and closes the doors. It is probably no surprise that liquidating the company results in the lowest valuation.
For business owners thinking about an exit, it is important to evaluate the purpose / intent and associated outcomes. Intentions and preferences can have a significant impact on the “walk away” value received. For any questions related to this article or, for business valuation guidance, contact Bryan Setz at bsetz@vlcpa.com or 800.887.0437.
