Smith Holland M&A Resources
Growth potential only goes so far when it comes to business valuation.
There are many crucial steps involved once a business owner decides to sell a company and get it ready for the market. One important step includes demonstrating to a prospective buyer the growth opportunities and future potential of the business. It goes without saying that buyers do not want to purchase a failing company with no positive outlook on the horizon. Therefore, the growth potential of a business helps leverage competitive offers since there will be more buyers and interest created around a growing company. Unfortunately, this does not always result in a higher business valuation and even though sellers want to sell it, most buyers won’t pay for future potential.
If there is one guarantee on all mergers and acquisitions (M&A) transactions, you can rest assured that sellers want the highest valuation for their company and buyers want the lowest purchase price possible. An experienced mergers and acquisitions advisor or business broker will use a number of techniques to increase the valuation of a company in order to get the seller the most money possible at closing. Recasting financial statements is the most significant tool that removes extravagant owner salaries, bonuses, non-cash and non-recurring expenses which increases a business’ earnings before interest, taxes, depreciation and amortization (EBITDA). This is important since valuations are primarily based on multiples of EBITDA, as there is no denying the past performance of a company. Consequently, if valuations or multiples are too high because a seller is trying to bank on the future potential of a business, they risk losing buyers who simply move on to other investment opportunities.
Implement Growth Opportunities Now
Every company has potential for growth. Sellers are emotionally invested and for this reason, when they prepare to sell a company on the market, they give an extensive list of growth opportunities and expect to receive a higher valuation for future potential. For example, a roofing company can claim that a buyer can double sales revenues if they get licensed and complete work in another state. The seller of a local business that doesn’t have an internet presence says if the buyer creates a website, net income will grow exponentially. The general idea here is that a company always has future potential but if a seller hasn’t implemented those growth opportunities before they go to market, the buyer is most likely not going to pay a premium for it.
Typically, buyers are experienced and chances are, it is not their first time purchasing a company. Since these buyers have bought and grown businesses in the past, they understand the cost associated with and appreciate the magnitude of implementing growth strategies. The initial questions a qualified buyer asks when presented with potential growth opportunities are why has the seller not already implemented those strategies, and what is the cost associated with integration? While this potential growth can be very lucrative for a buyer in the future, they are only going to pay a valuation on the past performance of a company, not a multiple based on income from growth and achievements they create in the future.
It is vital for business owners to implement any growth opportunities before selling a company. Regrettably, potential is worth more to a seller than a buyer and the only way for a seller to receive that added value from future growth potential is to start the foundation of those strategies months before selling, even if they are still in their infancy. By the time the seller goes to market, there will be verifiable data and statistics to warrant the higher valuation for the company. As a result, any increase in sales revenues or customer base can be used to justify a growing business and will add value. Even though most buyers won’t pay for potential, implementing these growth strategies early will give the seller both short-term profits and long-term benefits through an increased valuation based on higher EBITDA multiple.
Pro Forma Financial Statements
Pro forma simply means “for the sake of form” or “as a matter of form.” In the M&A world, pro forma financial statements are used as a method to present a company’s financial projections for the next 2-3 years. Buyers view pro forma statements the same as potential, holding little to no value since these are also based on future presumptions. Usually, calculations on these statements do not follow the generally accepted account principles (GAAP) and only highlight certain positive attributes of a company’s performance. In addition, most pro forma statements have unrealistic growth percentages and of course, constant revenue increases year over year (YOY).
What buyers do like about pro forma statements (albeit little) are the formulas and rationality that were used to create the projections. A professional M&A firm will present the proper projections based on actual YOY growth from the past performance of the company. This gives buyers a better understanding of predictable growth in the future, if company operations stay the same and no growth opportunities are taken advantage of in the short term. Another good reason, is to highlight or justify potential contracts that are expected to be signed or closed shortly. Technically, this does fall into the future potential category but nonetheless, it is still a good idea to walk a buyer through all contracts to better illustrate how a pro forma statement was developed.
There are many critical steps involved for a business owner once they decide to sell a company. An experienced sell-side M&A advisor will use a number of techniques to increase the value of a business for a seller. Recasting financial statements is a significant tool used to remove non-essential expenses that the buyer will not incur in the future and a legal way to increase EBITDA in order to get a higher valuation. Since buyers cannot argue the past performance of a company, valuations are based primarily on multiples of EBITDA. Growth opportunities and the future potential of a business help leverage competitive offers but unfortunately, sellers are emotionally invested in their company and try to overvalue that business based on potential.
Every company has potential but if a seller doesn’t implement those growth strategies before they go to market, buyers are most likely not going to pay a premium for it. It is vital for business owners to start the foundation of those strategies months before selling, so they will have statistics and historical performance data to warrant a higher valuation. Growth opportunities can be lucrative for buyers in the future, but they are not going to base a multiple off income growth and achievements they create for themselves in the future. For this reason, you can’t sell potential and it is important to have a sell-side mergers and acquisitions firm on your team to help clarify the best sales approach for your company before going to market.
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