Part 3 of 5 – Why the Buyer Paid More
Today I want to explore the concept of Risk and Valuation a little more, and then explain why the buyer of Toaster Installers Inc quite happily paid a Valuation of Adjusted Profit x 26.
(Click here for Valuation = Unadjusted Profit x 250 | Or here for Part 2 on valuation methodologies, aka ‘He’s not an idiot, he’s just your accountant’)
How much will you pay for my Briefcase?
This is my favourite way to explain business valuations.
Let’s say I’m sitting in front of you with a briefcase that contains $1 million in cash. How much will you pay me for my briefcase?
- You can count the money, and
- You can pay me after you take possession of the briefcase.
OK, OK, you want to lowball me like that?! I know your type (that’s why you make great clients). So let’s assume now it’s a competitive auction process – you and one other person, in the same scenario. How much will you pay?
Ultimately, I’ll end up selling the briefcase for pretty close to $1 million, maybe even more if it’s a nice briefcase that’s worth something. Because compared to losing the auction and achieving nothing, you may as well bid $999,999, take the million, pocket $1, and give me back the rest.
Now the conditions are changing
What if I don’t let you look at the money first? How much will you pay?
What if you have to pay me in advance, not afterwards? How much will you pay?
Now we’re introducing two variables:
- Risk, and
- Cash Flow.
The Risk depends on how much you trust me. My beautiful wife who trusts me implicitly would still happily bid up to the million dollars – she believes there’s no risk I’m bluffing.
But grab a Shark Tank judge who’s never met me before, and they won’t be so believing. They have to make a judgement call – how risky is this acquisition?
Your confidence will be somewhere in the middle. But I guarantee, without being able to count or see the money before hand, there’s no way you’re giving me $999,999 for my briefcase. It’s too risky.
Cash Flow is the other reality. Even if you were as trusting as my beautiful wife, it wouldn’t matter if you couldn’t lay your hands on the money to pay me.
And this is another reason why businesses sell for more, or less, than you might expect – if there’s only one bidder with the cash to close the deal, then they are negotiating from a position of power.
Profit is Past, Risk is Future
And this is where the accounting principles (as any good accountant will tell you) completely fall down. Because a Valuation of Profit x Multiple is looking at historic profit figures.
But an acquirer isn’t buying the past – they’re buying future profits. At best, past profits give confidence in future financial success. But they can also overlook the diamond mine that’s about to enter production.
So the ‘Multiple’ is looking at the future. The Risk involved dictates how long into the future the buyer is confident the profit will continue.
Have you ever wondered why the companies listed on the stockmarket sell for a Multiple (often calculated as a Price-to-Earnings Ratio) way above what a small business can achieve? That’s a risk assumption – investors believing a huge, listed company is less likely to fail than your small enterprise (plus some liquidity premium).
If you can convince a Buyer that your business is safe. If you can convince a buyer that your business is growing. And if you can make it easy for the buyer to pay the money. Then they will give you a much higher multiple.
If I somehow convinced you that my briefcase not only had $1 million in it … but that it magically refilled every Christmas … how much are you paying for my briefcase now?
Why the Toaster Installer Buyer Paid More
All of that theory aside, having been involved in deals ranging from tens of thousands to hundreds of millions, I know that Profit x 26 is an abnormally high number. I still managed to help my client negotiate it though! Here’s how.
1. Demonstrated Growth Story
This was the big one. Honestly, Toaster Installer Inc weren’t my best client – we would build strategic plans, they would go away “to implement them ourselves”, and they would call me back in 12 months because nothing had changed. (But hey, at least they called me back.)
Even then, we had a clear story to tell the buyer: here was our plan, here is how we implemented it, here was the growth that followed.
And here’s how we did it again.
And here’s the current strategic plan, and the growth we expect to come as a result.
Remember – the Buyer is buying the future, not the past. We could demonstrate successful interstate expansion. We had a strategic roadmap for more states and two international markets. We had every confidence that the business would be twice as big two years after it was sold … and so the Buyer had the choice to either pay us for that growth in advance, or wait and see and possibly miss out.
They paid for the growth in advance, because they were confident that our briefcase contained what we said it would.
2. Legislation Changes
Toasters are heavily regulated, as you would appreciate if you’ve ever tried to have a bath with one of them.
(As acknowledged, they didn’t really install toasters, but insert the trade or field services industry of your choice.)
Big government was coming. I won’t say whether it was or wasn’t related to post-COVID life, but the market was changing for my client in a healthy way – anyone with knowledge of the industry could see that the market would likely triple (or more) in the next decade.
Sell the future, not the past.
3. Strategic Buyer
Which brings us to the next reason they paid more – this was a strategic, knowledgeable acquisition.
When mid-tier business owners (with 12-96 staff, my target clients) ask me about selling their business my first question is “Can I buy it?”
This gives me a lot of insight – is it a business that runs itself so any idiot (like me) can do it? Is it hugely complex, or highly regulated (which would mean fewer bidders in our imaginary property auction)?
And if not me, then who is the person or company who would most value owning your business? Because chances are a competitor, or a supplier, or someone downstream from your services will pay a lot more because they can strategically leverage your business in a way that I simply cannot.
The Buyer in question exactly fit that description – he could tell me the Multiples achieved by several other companies in the space. And while none of them approached our magic number, he was happy to pay more because he knew his team could do what needed to be done to justify such a large sale.
4. Very Generous Vendor Terms
This was the last factor in the huge sale price – negotiate on terms, not on price.
You might be thinking my clients were silly selling their business with so much growth in front of them. But they were happy to, as long as they got “their number”. And in the final push to get to their number, I made sure the negotiations shifted focus.
I negotiate a lot – real estate prices, business sales, executive salaries. Too often the focus is on the dollars, not the terms.
Again with the housing example from Part 2. You have a valuation of $800,000, but confidence in today’s market that it will sell for $900,000 or more. Would you accept my offer of $2.5 million?
What if my offer had a Settlement Date of Christmas Eve … 2045? Suddenly, just by changing one of the terms of the contract, what looked like a great deal for you became a great deal for me.
So once the Buyer had maxxed out his clean, cash deal – the owners began to trade terms for more money.
That included a tiny upfront deposit and small monthly stipend, plus some generous vendor finance terms. Remember – this $5.8 million is going to fund my client for the next few decades, so it’s not necessary that they get it all at once. $5.8 million over 3-5 years was better, for them, than $4.5 million today.
Your mileage may vary. And if we return to the theme of today – Risk is Future – these terms moved some risk back from the Buyer and onto my client. It’s only fair then that the reduction of risk came with a higher price.
Now you have the full story of how we got to a Valuation of Profit x 26. By understanding that Buyers buy based on future risk, not past profit.
Buyers buy based on future risk, not past profit.– Jacob Aldridge, International Business Advisor
Accountants may not like it (though many do). Accountants may not understand it (though many do, they’re just not allowed to write it down). And after tomorrow, Accountants may not like me much at all (though I’m sure they’ll get over it).
So make sure you keep reading for Part 4 – How the Accountant almost killed the deal.