I once read an article that stated the conventional wisdom among M&A advisors is that 50% to 75% of privately owned businesses sell below their full market value. Of course, I read that after I sold one of my companies for about 70% of its market value. So yes, I believe it to be true. In my experience, this is still the case today even though technology companies (even during COVID) continue to sell for high multiples. So, the question then becomes–Well, why is this happening? How is it possible to only sell for say, $7M when you are really worth $10M?
After running multiple transactions as an M&A advisor, selling three companies (two on my own) and speaking to a number of buyers, I believe technology service providers (IT businesses) sell for less than they should for the following 5 reasons:
1. EBITDA Adjustments aren’t Understood
Most sellers have at least read articles on what EBITDA adjustments or normalizations are, but most sellers still don’t understand it completely and tend to understate those numbers. Here is an example: right in the middle of a transaction, my seller was informed by Microsoft that they had reached the next margin level due to their excellent sales track record during the last 12 months. Their margins going forward would actually increase by 10%. Because my seller had a good amount of subscription-based revenue, which could be counted on as future revenue. This change in margin would actually increase their bottom line by about $200,000 per year. And assuming they would sell between 5x and 6x EBITDA, that additional 200K could add another $1M – 1.2M to the selling price. No, that is not your typical (historical) normalization add-back, but it does affect the deal and the numbers going forward. In this example, it increased their sale value by 15% – again, in just one adjustment or future normalization.
There are other more common adjustments that we see that sellers many times miss or just don’t understand (See my post about EBITDA adjustments). Now with COVID, there are more add-backs that sellers can use as part of the normalization process such as:
- Lost/deferred revenue, including any temporary price reduction or increases
- Employee absence or severance costs, and re-hiring costs
- IT expenses to accommodate working remotely – more equipment, furniture, etc.
- Expenses related to termination of leases or other operating expenses.
While my goal in writing this article is not necessarily to advocate using an M&A advisor, you can see by just this example above that finding “uncommon” normalizations can easily pay the success fees you would normally pay your advisor. I learned that lesson the hard way when I sold my consulting practice many years ago.
2. One deal on the table, is like no deal on the table –
The first time I heard this, I didn’t really understand what that meant. What it means is that with one offer you basically have no leverage. You cannot negotiate one deal off of another and the buyer knows it. Too often partners sell their company to another partner, because it is the only offer on the table, or because they know that partner well. But just knowing the buyer well, doesn’t mean you will get the best offer. Of course, you can ask for a higher price because you know that what is being offered is too low, but your only leverage at that point is to move forward with the transaction or not. And given that most people cash the check in their head once they see a good number on a LOI, they march forward with the deal hoping in the end to increase the value. Or more realistically, an offer comes in from a buyer, which looks really, really good, but once due diligence is done, the offer is reduced for a variety of reasons. Without another deal at the table, it makes it much harder to negotiate something better, regardless of how solid your customer base is, or how unique you are as an organization. Again, a mistake I made first-hand. If you are approached by a buyer unexpectedly, do your best to find a second one, if only as they say in sales for “column fodder”. A good M&A advisor knows this and will always have multiple buyers at the table to allow for the best offer possible.
3. Improperly stated gross profit margin can change the deal at the last minute
This is a very common problem and yet not often discussed because who really likes to talk “accounting” except for accountants, right? But most offers or LOI’s are presented based upon the reliance of the gross profit margin (GPM) you initially shared with the buyer. You may think this doesn’t matter because it is just reclassifying expenses from one part of your P&L to another, but it is more than that. The GPM number is especially important to a strategic buyer. It is very likely going to reduce a lot of the general administrative and marketing expenses incurred by your company today as part of their economies of scale. What they typically cannot change (other than through buying power of common vendors or salary reduction of your delivery team) is your gross profit margin. Too often we see channel partners not accurately presenting a GPM margin because they forgot to add engineering labor, and the benefits, payroll taxes and other employee related expenses of those resources directly supporting the product up in the cost of goods sold. A good due diligence team will uncover this and may find anywhere from 10% to 20% more in expenses that just now took a great GPM and dropped it significantly. And guess what; so did your offer. And again, because most sellers are so far down the road once this comes to light, they try to negotiate the best they can to just get the deal done or worse have to walk from the deal.
Maybe, it’s the accountant in me, but properly and accurately stated financials will keep the final offer consistent with the LOI and prevent the deal from “re-trading” down. Invest early in a good accountant who can review with you your numbers annually. It will produce dollars for you down the road.
4. Deal terms are as important as price, especially during COVID.
No two offers are ever the same even if they are for the same price. We all hear about offers other partners receive for their companies, but not usually the details around the offer. And the details make all the difference even if the sales price is exactly the same. Here is a good example: Below we have two offers for $5M but with very different earn-out options and therefore very different outcomes. You really have to dig into the earn-out, and understand how it is calculated. Is it all or nothing? Will you have control or “get credit” for certain sales going forward? It is easier to design and track whether the earnings have been achieved during the earnout period when the acquired business is compartmentalized. On the other hand, if the operations of the acquired business are merged or otherwise integrated with those of the buyer, earnouts based on earnings become difficult to manage and track because both revenues and expenses must be determined.
Most sellers don’t focus on the specific details of the earn-out and that is why only on average 77% of earn-outs are actually achieved. (Source: Equiteq Trends Report)
Amidst the COVID-19 pandemic, we are going to see a greater emphasis on earnouts because buyers are concerned about future growth and want to conserve as much up-front cash as possible. And the COVID-19 pandemic will likely continue to have unpredictable effects on revenue and EBITDA, so sellers and buyers should be open to other approaches for earnouts.
As the seller it is important to view the earnout as frosting on the cake, meaning don’t count on 100% of that (possibly due to no fault of yours) to materialize. If you need this entire number to fund your retirement, you might look for a more secure offer.
5. Can the Management Team REALLY take over?
It is almost every sellers dream to receive a 100% cash offer at close AND be able to walk out the door a month later, but that is usually not the case in 95% of all transactions. While you might not receive a 100% cash offer the day you close, you can effectuate how long you stay. That all depends on the strength of your management team and how involved you are in the organization. You need to remember that you are selling the company and NOT yourself. Remove yourself well in advance from the day to day operations of the business if you really want to leave quickly post sale. A great way to show the organization can run without you is to take an extended sabbatical (four to six weeks). I go into detail on the added benefits of doing this in my book in the chapter called Management Muscle.
A savvy buyer will want to see how strong your management team is, and can the business remain successful long after you have departed. The true test of whether you think your management team is strong enough is if you are comfortable with them managing your earnout period. If the answer is no, or maybe, then you need to work on strengthening that team.
So, what do the above points mean for an owner looking for an exit? Forewarned is forearmed. Knowing and understanding the above points before you get started on a transaction can translate to a life-changing sum of money. So, the key here is preparation and planning. Don’t be surprised if it takes you anywhere from 2 to 4 years to truly prepare your company for a sale, especially if you need to strengthen your management team. But I promise, the extra time preparing will pay off in the end.
Insights from Closing 3 M&A Transactions During COVID