By Wes Shelton, CEPA, CM&AA, SM2 Advisors
Private capital markets are one of the great mysteries of our lifetimes. That may be just a tad bit of hyperbole there, but perhaps it’s well deserved. Over the next ten years, this country will see the greatest wealth transfer in the history of the world. No hyperbole needed. As U.S. Baby Boomers retire in droves, privately owned businesses will change hands en masse, to the tune of $6 trillion by some estimates. That’s more than the GDP of Japan.
Why such a mystery? Pick up the Wall Street Journal on any given weekday and you’ll easily find the current valuation of any number of publicly traded firms, down to single shares of stock. Private firms? Not so much.
There's no established market for shares of stock in private firms, and transactions that take place are highly shrouded in confidentiality. Financing is not as easy to come by for private firms, nor are they typically as well managed or staffed. They have less recognized brands, operational controls, policies and procedures, and capital. They reinvest less and have more lax hiring practices. Generally speaking, private firms are not nearly as well operated as publicly traded firms, and valuations tend to reflect that.
This gulf between public and private valuation is, in large part, driven by business owners who lack understanding of what actually drives enterprise value. They may have every bit of competence when it comes to driving profitability within their own firms, but profit and enterprise value are not the same thing.
The first and most prevalent fallacy among business owners is that value is purely a function of profit. My company has had business owners suggest to us that their businesses are valuable because of the type of industry that they are in. For example, a few years ago, we met with a man who owned and operated a large marine-based business in South Florida, a prominent industry in the area. When we asked him what he thought it was worth, he suggested a multiple over 10x earnings, which is unusually high. Why? Because, he stated, "It would be a cool thing to own."
The truth is, there are many factors that drive value in a firm. A few are universal, and others more industry related. Universal value drivers are factors like recurring revenue, customer diversification, longevity of key management, positioning in growth markets, defensible market position, etc. Industry specific drivers, for a manufacturing company for instance, could be factors like resistance to overseas outsourcing or proprietary vs. contract manufacturing products.
Two Categories of Value Drivers
All enterprise value drivers can fit into one of two categories: Risk and upside/growth potential. Buyers of businesses want low risk and high growth potential. If you can build a business where you mitigate risk as much as possible, and position yourself for high growth, you more than likely have a very valuable enterprise that would trade at a high multiple. Conversely, if your business has high risk and low growth potential, regardless of profit, you’re probably not going to get many offers.
These days, businesses with a recurring revenue component and low risk tend to trade at the highest multiples. That’s why so many types of enterprises are going with a subscription or membership-based model, even at a nominal monthly figure. They know that if they can get you to sign up, they’re unlikely to lose you, at least in the near term. Additionally, their business value just went up exponentially as a function of your yearly subscription fee. Transactional, seasonal or cyclical businesses, and businesses that sell discretionary products (like boats or jewelry) are generally less desirable because of the perceived risk.
Business owners often try to underplay risk, usually out of naivety, "We'll never lose that customer; he loves us." But buyers know where to look to find it. While risk can never be eliminated completely, it can be mitigated. Savvy business owners will seek every means possible to mitigate their firms' risk to increase value.
Sophisticated buyers look for businesses with significant upside potential and will pay big bucks for them, which is why software companies are so popular and regularly fetch double digit multiples. Scalability plays a big part in this. Businesses that exhibit flat or downward growth trends are extremely difficult to sell. Buyers want to know that they can not only maintain the current level of earnings, but grow them. If not, they will gravitate to an industry or business where they can. Buyers often search for well-managed firms whose growth prospects are constrained by lack of capital. This is especially true for private equity firms that are flush with cash and tend to prefer to partner with existing management rather than bring in their own.
Unlike risk, growth potential is not as easy for a firm to control. For a firm facing limited growth prospects, it could take years to roll out a new product or service, or enter a new market with the existing offering. Nonetheless, buyers will pay a premium for businesses that have significant growth potential and business owners should know that.
A frequent question that a prospective buyer asks during the sale process is, "How would you grow this business if you were me?" The sellers' response is always very telling. If the sellers cannot make a solid and clear case for growth, then the buyers usually lose interest. If the sellers are simply limited by capital, that's a problem that can be fixed.
There is a knowledge vacuum when it comes to business owners and how they understand value. The Exit Planning Institute estimates that four million businesses will change hands over the next ten years as Baby Boomers retire. Yet, many of these owners don’t know what their companies are worth and if they are prepared for retirement.
This represents a tremendous opportunity for advisors to add value to the exit planning process and educate the business owner on driving value in private enterprise, by putting a plan in place to grow that value before they are ready to "hang 'em up."
The online marketplace tells us that 70% to 80% of businesses that go to market never sell. That's because owners are not prepared. Some will hire trusted advisors to bridge this gap, and some will not.
As Benjamin Franklin would say, "By failing to prepare, you are preparing to fail."
Wes Shelton, CEPA, CM&AAworks at SM2 Advisors helping Nautilus member clients nationwide by providing valuable research, analytics, strategy and deal structuring to optimize outcomes. Wes earned his bachelor's degree from Southern Methodist University in Dallas, TX, and his MBA in finance from the H. Wayne Huizenga School of Business at Nova Southeastern University in Fort Lauderdale, FL. Wes also serves on the board of directors of several community focused organizations with a specific focus on helping foster children.
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