The Buyer’s Stretch Marks

“We were told if our revenue was greater than $5 million, we’d be an attractive acquisition target. We got there, but we’ve had to sacrifice profitability.

I met Charlie (not his real name) at the office of his wealth planner. They were developing a retirement plan for Charlie and his wife. They asked me to help them determine his company’s market value and discuss timing to sell it for maximum value. Charlie was just shy of retirement age, but the way he described his daily workload, I could tell he was ready to sell his business.

As we reviewed his financial history, it didn’t take long to realize that Charlie had a problem. His $5 million of annual revenue was generating about 3% of profit, and that’s what Charlie paid himself every year. Meaning, after he paid himself, Charlie’s business wasn’t making any profit. Since he was necessary to the daily operation of the business, it was generating no transferable value.

Charlie’s wealth planner said, “Don’t you think a strategic buyer, like a competitor, would love to get their hands on Charlie’s $5 million book of business?” I replied, “Selling to a competitor is often the best way to get maximum value for a business, but if you aren’t making money, why do you assume the competitor will overpay for it?” Charlie then said, “But a competitor could consolidate operations, eliminate some expenses, and that would increase their profits. I bet they’d love to do that!

Charlie’s answer was typical of what I often hear from an owner whose business isn’t making much money. They assume (or hope) they can sell their business to someone who will pay more than what it’s worth because of the buyer’s ability to make it profitable. That theory is true, in some cases, but when the business isn’t making much of a profit, it’s likely the seller will have limited potential buyers, and that’s what really limits the seller’s upside.

To be sure, Charlie’s annual revenue of $5 million will indeed be attractive to the right buyer. We are working on a target list right now. But I had to caution Charlie that the right buyer will not ignore the company’s financial under-performance when preparing an offer.

Here’s a mathematical explanation. Let’s say a competitor can buy Charlie’s business and eliminate redundant overhead and therefore improve operating margins from 3% to 10%. That means the buyer would be making $500K per year whereas Charlie can barely break even after paying himself a salary. Is the buyer going to value the company on that $500K of annual profit that they could make, or the $0 of annual profit that Charlie actually makes? Well, it depends on how aggressive that buyer is, but most buyers will not stretch their valuation to include all the upside they can create. Meaning, the buyer’s valuation formula will be based on annual profit between $0 and $500K. Now, if Charlie had several potential bidders looking at his company this way, he’d likely be able to get a buyer to stretch some. But, if there’s only one good buyer, Charlie cannot expect a buyer to stretch much.

I told Charlie and his wealth planner it would not be reasonable to expect a purchase price more than $1 million. I’m not saying he can’t get more than that, anything is possible, but I’ve met few buyers who aren’t discriminating with their investment dollars. Charlie might be better off to keep his company, keep making his $150K per year, and wait for a more competitive environment.

 

JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. https://www.amazon.com/Home-Pros-Guide-Selling-Business/dp/1599329239   He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The principles above are true, but the story, names and fact patterns are changed to preserve the parties’ identities.

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Tennessee Valley Group

Jim Cumbee established Tennessee Valley Group to help business owners fulfill their dreams for life after business ownership. It’s a mission that his 30+ year career history had prepared him well for—in addition to being an attorney, transition mediator and business broker, Jim has been a buyer, seller, and entrepreneur. His broad range of experience gives him unique insight into how business buyers and sellers can achieve their goals.

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