After a career spent buying and selling companies, I’ve learned that the essence of a deal comes down to this simple fact:
A company is sold when its value is greater to the buyer than it is to the seller.
This obvious statement raises the more complex question: Why is the value of the same company different for the buyer and the seller? This can also be answered in a simple, though perhaps less obvious, statement:
Value is the future cash flows to the owner over time, discounted by the owner’s risk discount rate.
Now, this starts to get more complex. The values are different because the cash flows over time will be different for different owners, and because each owner has a different discount rate. In addition, the discount for the same owner will change over time.
Here are two examples from the owner’s perspective:
- Think of a company owned by a relatively young person in his mid thirties. You don’t often hear of these owners selling their companies. Here’s why: for this owner, he expects to get a 30-year return of future cash flows. Plus, he will expect to grow those cash flows at a rate greater than inflation over the 30 years.Equally important, his discount rate for risk is low. His rate is low because he has a 30-year window to adjust and recover from the bad things that will happen along the way. He can weather a three-year recession and still be building value when the economy recovers. His health is good, so there is little risk that he will be forced to sell his company during a period of lower M&A valuations.
- Now think of a company owned by a person in his sixties. His future income stream is really only three or five, or maybe seven years long. He cannot expect significant growth in that income stream in those few years. He is not prepared to make extra investment of time or money to accelerate growth. Even if he had an idea to stimulate growth, there is little time to implement it, it would have risk and the rewards may come after he is retired.The other piece of this owner’s equation is that his risk discount rate is much higher. His company faces risks daily from the economy, increasing taxes, regulations, new competitors, lost key employees and his own personal health. With a short time horizon to recover, this owner runs the risk of significantly diminished cash flow when it is time to sell. The inability to recover from all these risks put a high discount on future earnings. The combination of these two factors – cash flow and risk – is exactly why owners decide to sell their companies when they approach the end of their careers.
So, what does it look like from the buyer’s perspective? To get a deal done, a buyer has to expect higher cash flows and a lower risk discount rate. Consider these examples of how two types of buyers value cash flow and accommodate risk:
- Strategic buyers are companies that buy companies that have synergies with them and that fit into the buyer’s bigger strategy. One of the big reasons acquisitions are more valuable to strategic buyers is that they count on an immediate step-up in the cash flows when they reduce operating costs by consolidating the companies. More powerfully, high-value strategic acquisitions step up cash flow because they give the buyer the opportunity to drive increased sales of the acquired company’s products to the buyer’s customers and to sell the buyer’s products to the acquired company’s customers.Equally as important, strategic buyers have a lower risk discount rate because the strategic buyer is a larger, stronger company. As a division of a strategic buyer, the acquired company can withstand external shocks that may have killed it as a stand-along entity. The strategic owner can bring in additional expertise to help shore up weak areas in the acquired company. Strategic buyers can tolerate more risk in a division of their company than the owner of a private company can tolerate.
- Financial buyers are institutional investors that acquire companies with the objective of earning a return on their investment by growing the company more rapidly than the seller is able and then re-selling the company in three to seven years. While strategic buyers get immediate cost savings, financial buyers expect to bring additional capital resources to the company that can support faster growth both through add-on acquisitions and organic expansion. To give comfort that the cash flow will continue under their new ownership, financial buyers frequently require that the owner and his management team stay on with the company for several years after the sale.While Financial Buyers have high internal return-on-investment expectations for their own investment, they typically have a lower discount rate than the seller. This is most often the case when the seller is over 50 years old and is reluctant to re-invest his own capital to grow or to take business risks that may hurt the value he has built in the company. To the institutional owner, the same company is one of a portfolio of investments owned by the financial buyer. The company’s short-term risks are less important to the institutional owner so their discount rate is lower.
The differences in value between owners and buyers are what drive all successful mergers and acquisitions. Deals happen when the value is greater for the buyer than the seller. What is important to both sides is the final price of the deal. The final price is dependent on each side understanding the other’s valuation metrics and negotiating the final price closer to their counterpart’s number.
Young owners rarely sell their companies because they have a strong future with time to recover from the bad things that invariably happen to private companies. Sometimes a buyer sees such huge strategic value in a young company that their expected earnings and low discount rate make it smart for them to pay a lot of money to acquire them. This happens most often in high-tech M&A (see companies acquired by Google, Cisco, and Yahoo). On the other side, owners who wait until late in the game have let their discount rate get so high that their value diminishes each year. Savvy financial buyers and strategic buyers like to buy these companies at the low valuation that is finally left for the owners.
For most of the private company owners I have worked with, the wealth they have built in their companies is more than half their total net worth. Whether they plan to sell in twenty years, ten years, or next year, it is important to keep track of what the value is to them and what the value may be to a qualified buyer. When the owner gets to a point where that value to him is less than the value of his company to a strategic or financial buyer, he should sell their company to lock in and preserve his wealth. Owners need to be thinking regularly about their expected future earnings and about their own personal discount rate. As these two variables change over time, their decision to hold or sell will also change.
posted by John Hammett