There are many drivers these days that may cause you to think about selling, merging or refinancing your business.
You may need to raise additional capital investment. You might be of an age that suggests retirement with no kin following in your footsteps. There may be a trend toward industry consolidation that changes the competitive framework. You may feel your industry is getting more competitive, and therefore, your company's prospects less certain. Whatever the reason, there are several important variables to consider before making a decision.
Generally speaking, valuation theory suggests that a business is worth the future cash flow the company will generate based on a formula that accounts for future growth rate and a risk-adjusted discount rate. Other indicators of value are comparable company analysis and the implications of minority equity valuation of appropriate listed companies.
For any given business, at any given point in time, value is greater when the stock market is higher and yields (interest rates) are lower. What this means is that today, with the stock market around 9000, near a historic high, and the prime rate at 8.5 percent, relatively low, buyers will pay more.
What this also means is that if the stock market retreats, or the interest rate increases, your company will be worth less even if its performance remains unchanged. In fact, maintaining value will require earnings growth that exceeds the downward pressure created by the retreating market or increasing interest rates. In other words, working harder may be necessary just to maintain value, even though the company would otherwise be nominally the same.
This is not a trivial concept because it implies that timing may be a very important consideration in the sale of your company, even if your company is still a work in progress. Why do owners resist selling even though the time appears right? Because few buyers, regardless of whether they are strategic or financial, can ever pay enough to make up for ownership of a successful business' cash flow.
For example, let's say that Sam owns a technology-based company. The company is presently showing revenues of $100 million, with pretax income of 10 percent. The company is an S Corporation and strategic buyers are offering $133 million in cash for the company.
Sam figures (correctly) that after state and federal taxes on the transaction totaling some 25 percent, he will have roughly $100 million to invest, which at reasonable risk will yield about $6 million per year less than the company is presently earning him, and he won't benefit from the future growth in earnings or value of the company. Sam reasons that if he continued to own the business, he wouldn't have to pay the tax, and he would have more cash flow each year. Furthermore, Sam feels that he will always be able to sell the company for $133 million.
What allows Sam to feel this way is his view of risk. He sees no difference between the risk in a sale vs. the risk in a hold. Therefore, he is attaching no value to the concept of certainty.
Even if, however, he is correct with respect to the risk in his business, he has failed to consider the risk in the other market variables that act on price, namely the levels of the stock market and interest rates. By holding instead of selling, he may be putting himself into a position of having to run harder just to maintain value.
But if he really has no short-term needs for the money, why should he care, since all markets are cyclical? Because experience shows that owner/operators regularly overestimate their ability to predict the future, especially the emergence of new competitors and substitutes, and oftentimes leave their lifetime best deal behind them.
Therefore, the timing of a transaction relative to the performance of the broader capital markets can have greater impact on price than the actual performance of a company. A buyer who can strategically enhance the value of his enterprise by capturing another company's market share, proprietary technology or other strategic advantages will be willing to pay a premium to make the acquisition. Indeed, this desire to gain strategic advantage through acquisition and to prevent competitors from doing so is one of the drivers of consolidations within an industry.
Today represents the best of all worlds for the sage CEO who recognizes our current environment as one of unique opportunity, brings his best skills to bear to prepare a company for sale, engages talented professional advisors, and reaps tremendous rewards for his efforts. However, the path to reaping these rewards, once the decision is made to sell, is not without peril.
The courtship and negotiation of a sale must be handled with the utmost privacy. Competitors are quick to use the news of an impending sale to damage a company in the marketplace. Or just as damaging, rumors of a sale can leave your sales and executive ranks ripe for the picking, putting a dent in revenues and earnings. Likewise, the knowledge of a pending sale can de-focus management and operations and adversely impact performance.
These risks can be mitigated with proper planning and quality advisors. Proper planning means being very sure of one's decision to sell and then continuing to run the business as if you were going to be there forever. Putting together a quality team comprised of experienced investment bankers, legal counsel and auditors is key. This team will maintain a confidential environment, be very judicious about what type of company information is made available, and perform due diligence on the buyers.
Rock Hankin is founder and chief executive of Hankin & Co., a management consulting firm, and Hankin Investment Banking. He also serves on the faculty of the Anderson Graduate School of Management at UCLA, where he teaches a course in business strategy and planning.
Entrepreneur's Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1941 with feedback and topic suggestions.
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