[Editor's Note: There is a lot of misinformation about the state of the market for lower middle market ($10M to $200M in revenue) companies looking to sell - either now or sometime in the next few years. I asked some of our clients to provide questions that are on their minds. Answers have been provided by private equity firms, intermediaries/investment bankers, business owners, and commercial bankers.
While fast-growing, well-managed companies are being sold at record prices, this article addresses a problem for many companies looking to sell - How to address a "value gap" or "needs gap" that has developed between the current market value of their business and the amount they need or expect to get from a sale. If you have any questions about this information or a question that we did not answer in the following, please do not hesitate to contact us. -dpm]
Question: How do I determine if my company has a value gap or needs gap?
Answer:
What many companies looking to sell are experiencing is called a "value gap" or "needs gap." This means that the company as it is performing or configured today will not achieve the sales price in the current market that it would have earlier. This gap is the difference in value between then and now.
Question: How do I know the current value of my company?
Answer:
We suggest to our clients that they contact a reputable investment bank or M&A intermediary who can estimate a market valuation range for your business. This market valuation is very different than a valuation that an organization might do for estate planning or tax purposes. An M&A intermediary will value your company based on the current market for companies of similar size, industry, performance, and growth. A common mistake that owners make is comparing their company to the valuations of large publicly-traded companies in their industry. The truth is that large companies trade at higher valuation multiples - sometimes much larger multiples - because risk is generally perceived as significantly lower than with smaller companies. An M&A intermediary or investment banker can determine the appropriate market valuation range for your business.
Question: OK, so now I know the estimated value range for the business. Now what?
Answer:
Once a business owner knows the estimated value of the company, it's time to figure out how much the owner gets to keep and to determine if that's enough. Consulting with a competent tax accountant, you can calculate the net proceeds which is the estimated gross value of the business less the legal, accounting, and intermediary costs to sell the business, less the tax bite that Uncle Sam may take. [Many times, there are built-in gains in the business that may make that tax bite significant - and your accountant and wealth management professional may be able to suggest ways to mitigate this BEFORE you sell.] Once you've determined the net proceeds, it's time to review this with your wealth management professional to determine how you might invest the proceeds to see if you will be able to support the lifestyle you expect.
Question: What if it's not enough?
Answer:
Then you and your wealth management professional must determine how much you do need. The Mead Consulting Group then helps clients develop a strategic growth and execution plan for the business, with specific steps necessary to achieve an increase in valuation in order to meet the owner's needs.
Question: Is that the needs gap?
Answer:
Yes. It is the difference between what an owner may need from the net proceeds of the company and what it's currently worth.
Question: Then what is the value gap?
Answer:
The value gap typically occurs when a company's performance slips. A company may have had a valuation of $1,000 in early 2022, based on certain performance projections for growth of revenue and cash flow. If the company has failed to meet those projections for 2023, it may now only have a valuation of $700. The difference between the previously "expected" value and the current market value is the value gap. The gap may actually widen if buyers begin to suspect that the business may have additional unknown risk. It is an uncomfortable place for all parties and typically the company is taken off the market.
Question: So, what happens with a needs or value gap? Am I stuck staying with the business?
Answer:
Please note that in some cases, it may not be possible for a business to grow sufficiently to add enough value to meet an owner's needs, due to an aging industry, product obsolescence, etc. If that's the case, however, business owners tell us they would rather know that as soon as possible so they can possibly take other steps.
However, we have been pleasantly surprised over the years at how many businesses can achieve their needs with a good plan and great execution. Many businesses become a "lifestyle" business over the years, supporting the income needs of the owner. As a lifestyle business, many companies are worth more to the owner than to a prospective buyer looking for a return on investment. By focusing on the primary drivers of value for the buyer, a business can be transformed into a much more valuable entity.
Question: What are the drivers of value for the buyer?
Answer:
What are buyers looking for? It comes down to four things:
1. History of revenue and profit growth
2. Strong cash flow or EBITDA
3. Strong management
4. Opportunities for growth
In order to get the best price, you must be able to present a company that the buyer can see will bring them a reasonable return on their investment. That means the business must have the potential to grow and have management that is knowledgeable in the industry that will help them grow the business. For more detail see "Prepare your company to be bought."
Question: Does that mean that businesses that don't have the four value drivers won't sell?
Answer:
No, but what is true is that flat businesses, or those with an inconsistent history, are less desirable and therefore are typically "discounted" by buyers. Businesses without the four drivers have a higher risk of not meeting the desired investment return. Simply stated - higher risk means a lower price.
What is happening in today's market is that buyers are being more selective, and those companies perceived as "less desirable" are either not sold because banks will not provide debt financing, or they are being deeply discounted.
Question: How long does it take a company to transform from a lifestyle business to a value business?
Answer: That depends on a number of factors. Based on the dozens and dozens of companies Mead Consulting has worked with, we would say it comes down to 12/24/36. That's 12 months, 24 months, or 36 months. We have found that by focusing company management on the key drivers, an organization can be ready to go to the market in as little as 12 months, but more typically it's 24 or 36 months. See "Maximizing Company Value at Exit."
We assist a company with direction and resources, but a lot depends on the commitment and discipline of the owner and management team. We tell business owners that there is no magic button to push - it's hard work. But, most successful owners agree that it's worth it. Many times, we can accelerate the process by helping the owner stay focused and hold himself/herself and the management team accountable for progress.
Question: How much progress can a company make (over 12/24/36)?
Answer:
We've seen companies with needs gaps improve valuation by as much as 500% over 36 months. An example is a $50M revenue client company that had a 16X IMPROVEMENT IN EBITDA over a 36-month period. Another more recent client valued at $16M sold for $80M three years later. While these situations are possible, it is more typical to see improvements in value of 30% - 50%.
Question: As a business owner, what should I be doing?
Answer: Act Now! While this is currently not a Sellers' Market, start today to work on preparing your business to meet the four value drivers so that as the market changes in 2024, you can be well-prepared to maximize value.
For more information, also see "Common misconceptions about selling a business"
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We can help. The Mead Consulting Group has helped dozens of clients prepare for successful sales transactions ranging from $15M to $350M in transaction value. We help companies increase the value of their businesses leading up to a transaction, minimize the things that cause potential buyers to discount the price, prepare to best position the company, and assist the owners in building a transaction team. Check out our website for descriptions of some client success stories.
If you would like to discuss how we might help your company begin the process of adding value, please contact us for a free consultation.
Best regards,
Dave Mead
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