By G. Stanley Cutter, Partner, FOCUS Enterprises, Inc.
Many business owners mistakenly assume that they will receive the “value” of their firm in cash as proceeds during a sale. This expectation is further compounded if the business owner has received a formal valuation from a valuation professional.
While any experienced M&A professional can cite numerous factors as the specific reasons for the difference, one key reason is that the valuation may not reflect the actual market price for the company. It is important to understand the reasons why an owner may not receive the perceived value of the company in cash as well as what an owner may actually receive as total compensation.
Buyers May Apply Assumptions Completely Different from Professional Valuators
The gap between valuation and proceeds starts when the valuation does not reflect the practical results from the business enterprise when measured by the strength of its earnings. Professional valuations rely upon an assumption that there is a “willing buyer and willing seller.” Most professional valuations experts will carry out a company analysis centered on three areas: cash flow, asset value, and comparable transaction analysis. While each area of the valuation analysis will result in an answer, the “art” of valuation is in producing an opinion or result that combines the data gained in each of the three areas being studied.
However, an actual buyer may apply different assumptions to determining a company’s value, based upon the buyer’s practical operating plans. This difference in basic assumptions is the first opportunity for a buyer to stray from the valuation results produced by the professional. In addition, real world buyers may discount some of the techniques used by the valuation expert as well as the resulting valuation analysis.
For example, a formal valuation often will take into account the appraised value of real estate, while an actual buyer may be intent on moving production to an existing facility. The buyer will exclude the real estate from the transaction, leaving the seller to realize the real estate value in a separate transaction. Thus, the value of the business will not reflect the value of the real estate—which may have been included in the valuation produced by the professional.
EXAMPLE—Real Estate Value is Not Necessarily Included: A seller received an offer for a business valued at $8 million by the buyer. Upon examination, the offer was an asset purchase for $4 million in cash, $1.2 million in assumed liabilities, and a term note for $800 thousand. The seller retained $2 million worth of real estate. In the year of the sale, the seller’s after-tax cash proceeds were less than $3 million. The real estate was sold later and the note paid over three years.
Forms of Payment Can Affect Total Compensation
A second source of the gap between a formal valuation and the actual transaction value (or total compensation) is a result of the various forms of payments present in a transaction. In both private-company and public-company transactions, the bundle of assets are not always paid in cash, and often include notes, assumption of existing liabilities, employment contracts, and other compensation agreements which are paid over time.
The seller, who is receiving notes and other deferred compensation, will value each portion of the compensation at different levels from the buyer. Any reader of the financial press has seen a statement saying that “the company will receive cash and notes for a transaction valued at…etc.” Fine reading of public transaction records show that most transactions combine cash, stock, and assumption of debt in order to reach the transaction value. In private transactions, the creativity of the parties involved--along with the desire to accommodate specific needs of sellers--often creates a structure that is difficult to evaluate.
Different Tax Positions, Legal Structures, and Time Horizons Affect Results Substantially
As transactions are structured, each party often has different tax positions, is using different legal structures, and has different time horizons, resulting in substantial gaps between the formal valuation and the transactional result. For example, to reach total compensation acceptable to a seller, the buyer may offer contingent payments based upon performance in an employment contract. Such payments raise the total compensation, provided the triggers are reached, but if they are not reached, the buyer has no obligation to pay. From the seller’s point of view, the triggered event may be attainable when the contract is signed, but may not remain so due to unforeseen events. When discussing the value of such payments, each party often will discount the payment using both different discount rates and tax rates.
Business Owners May Underestimate Their Personal Influence on the Value of the Company
Another major assumption that causes a difference between a formal valuation and the actual transaction result occurs when values are not adjusted for the unique strengths or weaknesses of the owner. Most owners play key roles in their businesses as head of sales, chief administrator, chief operating officer, or in similar value-enhancing positions. When a company’s value is determined, one assumption is that the company will continue to operate over time as it has operated previously.
During the transition to new ownership, the original business owner’s role will change, and this is likely to have a direct effect on the business valuation. A clear understanding the ability of the management team—functioning without the original owner—often is an omitted ingredient of a valuation, and this can cause actual transaction values to differ. Buyers will discount the transaction price if they perceive that the role of the owner is uniquely vital to the success of the business and/or that the remaining management team is weak or incomplete.
EXAMPLE—Perceived Owner Influence Lowers Value: A professional valuation indicated a value of $7.5 million based on historical performance. Nine months later, the owner received an offer of $5 million comprised of $3 million in cash and a three-year note for $2 million. The buyer of the injection molding company believed that the seller had a unique relationship with three key clients representing 75 percent of the company’s revenue, and was concerned that the clients would leave when the company was acquired by new owners.
Strategic Buyers and Private Equity Groups Approach Valuation Differently
Strategic buyers and private equity groups each approach valuation quite differently, and for valid reasons. The strategic buyer often is more interested in the benefits of adding a product, a service, covering new clients, or other strategically important internal issues than a private equity buyer. The private equity buyer may be less willing to pay a competitive price because they may be new to the industry, cannot benefit from post-transaction cost savings, or are using the sellers’ company as an addition to ongoing activities, unless they are adding to an existing investment.
Steps Owners Can Take Before Offering a Business for Sale
There is a long list of additional reasons that the value of a company and the proceeds of a transaction differ. A business owner contemplating a future sale is well served by receiving advice about the process and planning for the event. Use of appropriate advisors will assist the business owner in understanding the practical issues faced during a transaction. For example, by carrying out advance work, a business owner can make certain that any intellectual property owned is well protected before a transaction begins. Appropriate legal reviews in advance of a sale also will mitigate any confusion or problems that might occur during the buyer’s due diligence process, resulting in a price reduction.
Similarly, environmental reviews, including Phase I environmental studies where appropriate, will smooth discussions and eliminate a buyer’s argument for reducing a price due to unknown problems.
EXAMPLE—Eliminate Environmental Concerns: One seller avoided environmental hazard questions when selling by carrying out a Phase I environmental study on his turn-of-the-last-century building which had been the home of at least five different businesses. Based on the study, a remediation plan was underway for the minor problems identified, saving substantial discussions, and avoiding any reduction of selling price due to environmental issues.
By knowing these types of answers in advance--a review of intellectual property; appropriate legal review; and Phase I environmental study--as well as by having a plan to remedy potential problems, a business owner can virtually eliminate discussion about the impact of some issues, thus weakening a buyer’s ability to reduce price during negotiations.
Maximize Results by Understanding the Impact of Different Transaction Structures
Before the intensity of business transaction begins, a wise business owner has an opportunity to plan ahead and to understand the impact of different types of transaction structures. While many sellers prefer the sale of stock, many buyers prefer to purchase assets. Understanding the tax basis of both stock and assets to be sold--as well as the liabilities existing which may be retained--will help an owner structure a beneficial transaction. By understanding each structure and the potential results, the seller can better plan and position the company to maximize personal results from a transaction.
Working through the list of issues faced by a business owner planning to sell a business can be a daunting task. However, the rewards are substantial. By taking steps in advance to enhance value and streamline diligence, a business owner can expect to attract buyers who are prepared to pay higher prices.
Stanley Cutter and Michael Zook, both FOCUS Partners working with the FOCUS Midwest Region team in Chicago, have developed a structured review for business owners wishing to understand their “transactional” value and strategic value enhancement opportunities while planning for the future.