How much is a company worth? – The deal risk tug-of-war

The deal risk tug-of-war

The sale of a business is always a negotiation.

In a perfect world, the buyer wants to make great returns with little or no risk. The seller needs to figure out just how far the buyer will budge from that dream position. One has to answer the question – How much is a company worth?

Even if you haven’t been part of the sale of a business before, you’ve had exposure to negotiations in your life. You may not remember, but they started when you were a toddler. The average 3-year-old doesn’t fight fair in a negotiation. In far too many cases, buyers and sellers of businesses seem to revert to the approach they used to take in the sandpit when negotiating a deal! Unfortunately, the subject matter at hand isn’t a lollipop or toy. No, in this case we are talking about someone’s life’s work. But what drives these negotiations and how can buyers and sellers get closer to a deal and agree how much is a company worth?

The extremes: a perfect world for each party

Let’s start with what the seller wants. It’s very simple, really. A seller wants to be paid as much as possible, up-front, with no ongoing risk in terms of receiving the cash. Where the seller is also managing the business day-to-day, the ideal scenario is no transition period. The buyer must magically walk in on the day that the deal closes and start running the business.

The buyer wants the exact opposite. The dream deal uses the business to pay for itself, commonly called an earn-out (when there are conditions) or a deferred payment structure (no performance conditions). In other words, the payments should be spread out over several years and funded by the profits of the business. Of course, it really helps if the value is as low as possible, maximising the chance of a strong financial return for the buyer. It would also be lovely if the existing management team stuck around for a few years to ensure a proper handover of the business.

Can you see the problem here? The parties each want something completely different. That’s why a deal is a negotiation, as the parties have diametrically opposing interests.

Humans have human needs

To make the situation even more complicated, this isn’t just a financial negotiation. We often refer to valuations as being an art and a science. The same is true for the entire negotiation process, as there’s a rather intoxicating cocktail of financial metrics and the very real human considerations around the stage of life of the founder. Some founders want to stick around for a handover. They aren’t ready to go off and play golf five days a week. Others are desperate to move on, either because of burnout or some kind of personal crisis. This is why it literally pays to plan an exit well in advance, as a willingness to stay in the business for a handover period can give a real boost to the selling price and the prospects of finding a buyer. Demanding an immediate exit takes the likelihood of success to almost zero for a private company sale unless there’s a very strong team of professional managers and the founder has limited involvement anyway.

How much is a company worth? Don’t forget the time value of money

Time is money. We’ve all heard this before, although it isn’t quite used in the context of the time value of money. The concept is straightforward: cash is worth more today than in a year’s time. This is because of inflation and the opportunity cost of not being able to invest that amount in the interim period if the cash is only received later. This is precisely why buyers love spreading out payments, as they hang onto the cash for longer. For sellers, there’s a double-whammy of risk here: the inflation / opportunity cost and something much worse, being the risk of never being paid. Unless the seller has some kind of guarantee from the buyer or another party with a strong balance sheet, the business failing during the deferred payment period means that the seller is never getting paid. This is why many founders will choose to stick around for a handover period while the earn-out or deferred payment period is running, as this gives them a front-row seat to the health of the business. Without well-considered legal protections in place, that still might not be enough to avoid a crisis.

How much is a company worth?

Earn-outs as a tool to drive the value higher

Sellers want to be paid for future value that the business will hopefully create. Buyers only want to pay for the track record, not the promises on a PowerPoint slide. The trick to bridge this gap is to use earn-outs, although these come with the risk of non-payment that we highlighted above. An earn-out shifts the risk from the buyer to the seller. It is an appropriate tool in cases where the valuation is heavily influenced by future prospects that are different to what has been achieved in recent years. The buyer may be willing to pay for that favourable outcome, provided it actually gets delivered. If the seller is confident of the plans, then an earn-out is practically the only way to agree on a final deal that sufficiently rewards the seller for the quality of the business and mitigates risk for the buyer in case plans don’t work out.

How much is a company worth? Preparation is everything

Selling a business is complicated and goes beyond just the valuation. At bizval, our goal is to empower entrepreneurs in this process. Although the valuation (and understanding how much is a company worth) is clearly the critical starting point in any exit strategy, it’s also very important to consider a holistic exit plan and strategy that addresses the key stumbling blocks for a potential deal well before going to market.

Speak to us about your exit plan and how we can assist you in preparing for the negotiation of your life.