The odd one out can sell too cheaply

Many businesses are predicted to change hands in the next five years. What business owners don’t know is that they will be settling for a lower sales price. By TOM McKASKILL

By Tom McKaskill

With so many businesses predicted to change hands in the next five years, many business owners will be rubbing their hands. But what they don’t know is that they will be settling for a lower sales price – and sometimes at the urging of their advisers.

Anticipated growth in net earnings can have a significant impact on the sales value of a business, but few business owners create a selling scenario where growth potential is demonstrated. Growth potential is often growth that the buyer can exploit, but that the owner is unlikely to or unwilling to exploit.

While most business advisers declare that a vendor cannot get paid for growth potential that the buyer has to achieve, there are ways of extracting a premium on sale from growth potential, which the vendor creates.

The value of a business is generally held to be the net present value (NPV) of the stream of future net earnings. That is, the projected profits from the business are discounted using a risk factor to arrive at the current value of the investment.

This provides an estimate of what a buyer is likely to pay for the business. That NPV is thus highly dependent on both the estimates of projected future earnings and the discount rate utilised in the calculation. Higher estimates and a lower discount rate will both influence the current value.

Normally, the projected earnings are an extrapolation of prior results, but changes in the business capacity and/or capability or in the product/market mix might generate a very different future expectation, and thus a very different valuation.

Buyers will generally accept projections of future revenue where these are based on revenue-generating capabilities already demonstrated by the business, but they will be seeking clarification that those revenues are reasonable certain.

But what of growth potential that the existing business is unable to achieve but that the buyer, with better capabilities or greater capacity, more determination or a willingness to put more energy or hours into the business, might be able to achieve. Surely the buyer would not be willing to part with some of the increased value generated through their own efforts to the seller? Wrong! There are in fact situations where the seller can get paid for such growth potential.

The key to such a premium lies in two factors. First, the extent to which the seller is able to demonstrate that the buyer will be able to achieve growth potential, and second, having a number of equally able potential buyers compete for the right to undertake such growth.

The former is achieved through a clearly articulated plan for growth which is underpinned by good evidence. The task of the vendor is to show potential buyers how the business can be grown to generate higher levels of net earnings and that the higher revenues and profits can be reasonably achieved. Providing the vendor has a number of competing bidders, he can trade one off against the other until he has the best price.

This works. I have been able to identify a number of situations where a premium on sale was achieved where the buyer was convinced of the growth potential of the business even where the vendor was not able to extract that growth themselves.

The key to such a premium was that the potential growth had a high probability of being exploited by the buyer and that there were several potential buyers bidding for the opportunity.