Article published with permission from Tidwell & DeWitt and Ran One
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Four Pitfalls to avoid, when selling your business
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This Newsletter is focused on helping business owners assess the risk inherent in owning and running a privately held business. Understanding this risk measurement is critical to assessing an Exit Strategy because it helps a seller understand the value that a buyer will place on that business.
The saying ‘there is no RETURN without RISK’ is taught in Finance classes around the country. RISK is measured in many different ways including ‘default’ risks, ‘credit’ risks, ‘country’ risks, ‘volatility’ risks, as well as ‘opportunity cost’ risks – to name a few. These risks exist for publicly traded, liquid securities as well as for privately held, illiquid business interests. However, the two RISKS are measured differently.
Many business owners believe that the risk in their business is ‘controlled’ because they run the business. This is, in part, true. However the riskiness of any business, as a whole, can be measured more accurately by examining what a buyer would be willing to pay for a controlling stake in that privately held business.
A selling business owner should ask ‘What would my businesses’ return on investment be to another buyer?’ Often times it is surprising to see that buyers are looking for an annualized average return from the business of fourteen (14) to thirty-five (35) percent. Higher perceived risks [to the buyer] result in lower offers for the business. And, the fourteen (14) to thirty-five (35) percent expected returns translate into selling multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of approximately 2.8 times to 7.1 times – for a majority / controlling stake of the business.
By contrast, liquid stocks (i.e. publicly traded shares of stock) trade at multiples in the mid-teens to low twenty times EBITDA – for minority ownership positions. These higher trading multiples translate into lower overall expected returns.
So why would a buyer of publicly traded stock be willing to accept only a 5% expected return, but demand a 14% to 35% return from owning privately held stock?
The difference in these perceived RISKS can be explained in many ways. Primarily, liquid stocks have a ‘ready market’ for the trading of shares. Therefore, there is liquidity for those investments – which lowers some of one’s RISKS. Next, publicly traded companies disclose all ‘material’ items to their shareholders – this creates information transparency. Also, publicly traded companies have a broad access to capital. A call to their investment banker opens the opportunity to access capital either in the form of equity – by issuing more stock, or in the form of debt – by issuing more bonds.
We believe that private companies lack liquidity, transparency, and access to capital.
A business owner who wants to Exit their business should be aware of the various methods by which an Exit can be directed. Thereafter, consideration should be given to that business owner’s motives. In other words, what is most important to that Exiting business owner and how can it best be accomplished?
Knowing the RISKS of a privately-held business is a critical step in choosing what Exit path to follow. Armed with such knowledge, a selling business owner can either choose and ‘internal’ path – which may measure certain RISKS one way, or argue the RISKS of ownership point for point with an ‘external’ buyer. If the analysis is well documented, the seller may increase the price of their business under either method. And, regardless of the ultimate Exit path, the business owner will be well informed heading into the transaction.
Exit Strategies are hard to design and even harder to properly execute. We are pleased that you are pursuing a pro-active interest in Exit Strategies because a pro-active approach to an Exit Strategy is the only approach to a successful Exit Strategy.
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Measuring Risk in Privately Held Businesses
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Copyright Henberger Group Inc.
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