When an owner decides to sell a business, the first question is always, “How much is it worth?” Expecting a magic number or a one-size-fits-all valuation, the owner is frustrated when told, “That depends.”
“There are lots of reasons to value a business, but when it comes to selling, the parties involved and their unique economic characteristics and points of view are critical to placing a value,” says Mario O. Vicari Jr., director in the Audit and Accounting Group at Kreischer Miller in Horsham, Pa.
The price depends on what buyers are willing to pay, and there are different types of buyers who seek opportunities for various reasons.
Smart Business asked Vicari to explain why buyers value businesses differently and how owners should tailor their valuation expectations to suit the circumstances and buyer motives.
Why are there different ways to value a business?
I get calls all the time from business owners who say, ‘I need a valuation.’ The first question I ask is, ‘Why?’ You may be selling the business, or you may need a valuation for the IRS because you plan to make a gift as part of your estate plan. The purpose of the valuation and the parties involved dictate how your business will be valued. The value of a business could vary significantly depending on the purpose and unique points of view of the parties involved.
Say an owner is selling a business to a potential buyer. How will the valuation vary depending on the participants?
There are generally three categories of buyers. One is the internal buyer, and that might be a family member or employee. The second is a financial buyer, an outside party, such as a private equity fund that wants the business for the purpose of creating returns for investors. The third type is a strategic buyer. This buyer is typically in the same industry as the business owner and has unique reasons, at a strategic level, for wanting to add the business to an existing enterprise. Some of those reasons may include taking advantage of operational synergies or gaining market share. Each of these buyers’ motives vary, which means each will value a business differently and approach the sale with different goals.
How might a valuation play out for an internal buyer?
An internal buyer usually has an emotional attachment to the business. The buyer is already committed to the business as a long-time employee or as a family member. This buyer typically plans to continue working in the business after purchasing it and usually intends to hold it for a long time to continue his or her career or the family business legacy. The internal buyer is typically the most conservative from a price standpoint because of a lack of capital. That shortage of funds makes this buyer’s cost of capital high because of the need for personal guarantees and the investment of life savings to fund a transaction. In doing this, the internal buyer takes on a significant level of personal risk in funding an acquisition and, therefore, cannot afford to overpay for a company. That said, an owner still may choose to sell to an internal buyer if he or she is motivated to control who buys the company.
What about the financial buyer?
A financial buyer looks more strictly at the numbers and the long-term growth potential of the business as an investment asset. This type of buyer is typically a private equity fund, which raises capital from investors. This capital is deployed to acquire businesses that will provide returns on capital in the future. The financial buyer’s principal concern is to get a certain level of ROI for investors. This buyer usually supplies growth capital and management to the company to help it grow much faster than it could on its own and typically establishes a time frame for reselling the business to maximize returns. While the financial buyer will typically pay more than the internal buyer, the requirement to provide ROI for investors ultimately dictates the price.
Why is a strategic buyer willing to pay the most?
A business likely will hold the greatest value for a strategic buyer who has very unique reasons why the business fits with his or her current strategy. These reasons could include geographic expansion, increased market share, line extensions, access to new markets and the elimination of a competitor. A strategic buyer is often in the same or a related industry as the seller. This buyer sees the business as having synergistic value when combined with an existing business and, therefore, as having significant value. This buyer tends to keep businesses purchased to increase the worth of an existing business. For that reason, a strategic buyer is usually willing to pay a high price to acquire a business.
What should business owners consider before they get a business valuation?
Ultimately, there really is one value for a business, and that is only realized when the buyer and seller shake hands and make a deal. However, up to that point, the unique facts and circumstances of every case the seller’s motives, the buyer’s cost of capital, the quality of the business and its performance, among many other things drive the outcome of the valuation.
MARIO O. VICARI JR. is a director in the Audit and Accounting Group at Kreischer Miller in Horsham, Pa. Reach him at (215) 441-4600 or email@example.com.