27 May You Can’t Sell Potential
In our work with business buyers and sellers, there’s always a disconnect between what the seller wants and how much the buyer wishes to pay. It’s a very natural phenomenon. The struggle throughout this process is where do you draw the line when it comes to trying to increase the value of the business while still maintaining the overall integrity of what the actual EBIT might be? One thing for certain is that you can’t sell potential. History is the only real indication of future performance.
In the process of preparing businesses for sale, we frequently do things like make adjustments for personal expenses, reduce owners’ salaries down to market rates and do various other logical and ethical “add backs” for one-time exceptional expenses. Such adjustments typically occur over the historical past for as much as five years. If their bookkeeping has been done properly, this process is typically quick.
What about the pro-forma?
In every Offering Memo, you’ll typically see some type of proforma expectation of where the company is expected to go in the next four to five years. Buyers always view these numbers with a big grain of salt, if at all. The numbers are always heading north and–from what I’ve seen–the projects and percentage growth outpaces what was couched in the historical numbers.
The only thing “potential” does is helps to solidify in the seller’s mind the idea that the company is not going anywhere, that demand for the company’s products/services is at least steady (or hopefully growing) and that the business isn’t hiding any skeletons in the closet.
Many buyers also like to see the logic behind the pro-forma assumptions. Walking them through assumptions for growth can help them make their own determinations and assumptions on value and potential.
New potential contracts
Another way sellers work to boost demand and perceived value of their companies is by speaking about the potential contracts or those they expect to close very soon.
We had a recent client who was working with several potential Fortune 500 clients with contracts in the wings, but none of which had closed yet. I’m even convinced at least one of the contracts they were working on would hit, but the buyers didn’t consider it in their valuation of the business. This particular client already had too much customer concentration. The risk was still too great for the potential buyer that they couldn’t justify increasing their offer.
You can’t sell potential
When buyers take the time to place their offer of value for a business, they almost always start as conservative as possible, especially if they’re a financial buyer (as opposed to a strategic buyer). In the process of working to increase the offers on a particular company, the seller and his/her advisor will discuss growth assumptions, potentially new contracts and areas of untapped growth for the company, but ultimately most buyers only consider historical 12 month’s earnings in their valuation calculation for multiples.
Sellers are often like to point out all the potential areas for growth which they themselves never pursued for one reason or another. In truth, you can rarely sell potential, unless of course you’re working with a highly motivated strategic buyer willing to pay a significant premium for the company. Some may be convinced, but more sellers could benefit from looking at their business objectively from the buyer’s perspective. We’ve seen many sellers who’ve received reasonable offers which they ultimately rejected because they felt the buyer didn’t increase an offer to what they perceived as the potential growth. Sadly, potential isn’t a great criteria for valuing a business for acquisition.