We repeat this statement so often because lack of preparedness is the single biggest derailer of strategic growth and end-game plans, including exiting with the reward you deserve. What we don’t talk about enough, though, is one of the most crucial steps in the exit planning process—a step far too many business owners neglect to take early or often enough.

Obtaining a professional business valuation.

A professional business valuation opens the door to smarter growth decision-making and planning, increases your leverage in negotiations, maximizes your financial return and more.

Here’s why having an investment banking firm conduct a formal business valuation is so vital to your company’s growth strategy and to your personal exit strategy.

Why Business Valuation Matters in Exit Planning

Determining Your Company’s Worth

While you likely have a general idea of your company’s financial health and worth, a professional business valuation provides you with a data-informed analysis that’s essential for charting the path to your exit.

Most importantly, a formal valuation prevents you from undervaluing or overestimating the value your business.

It results in a backable and fair price.

Increased Buyer (and Seller) Confidence

Prospective buyers perform their own due diligence before making an offer. However, presenting buyers with a professional valuation conducted in advance creates additional transparency, boosting buyer confidence and leading to smoother negotiations.

It also allows you, the seller, to enter the buyer’s due diligence phase with additional confidence. After all, you’ll already know what their process will reveal about your company.

Understanding of Value Drivers and Weaknesses

A professional valuation showcases the primary value drivers of your business — all the factors that increase the appeal of your company to prospective buyers.

Value drivers include both tangible and intangible aspects of your business and operations. For example, recurring revenue streams, strong customer relationships, intellectual and other capital and proprietary technology are all value drivers.

A valuation will also uncover your company’s weaknesses — and this is where having an investment banking firm perform a formal business valuation far in advance of your exit pays back tenfold.

By assessing your company’s weaknesses early on, you’ll have the time required to properly address them and therefore ensure your business attracts a higher price.

If you consider how long it takes to implement even small organizational changes, you’ll recognize even more fully why being able to start course correcting well in advance matters.

Achievable Exit Goals

The sale of your business is not your end-game. Your end-game is living the life you envision post-sale.

A professional valuation gives you a realistic expectation of what you can achieve.

With this knowledge, you can adjust your financial strategy and if necessary, your timeline, accordingly.  

Why Involve an Investment Banking Firm in Your Business Valuation

There are various methods for determining the value of a company, but working with an investment banking firm has serious advantages.

Accurate Market Intelligence: Investment banking firms have access to real-time market conditions, sector-specific insights and other data. Their sources of information are what ensures your valuation will be comprehensive, accurate and relevant.

M&A Experience and Expertise: Investment banking firms specialize in positioning businesses for sale, identifying ideal buyers, structuring deals, navigating negotiations and closing sales. Your investment banker has the experience and expertise to guide you through every step you need to take, from developing your exit strategy through actually exiting on favorable terms.

Existing Relationships with Strategic and Financial Buyers: Investment bankers also have access to high-value buyers and proprietary deal flow. In other words, they already know those who may be willing to pay a premium for your company.

When to Perform a Business Valuation

Business owners should have a valuation performed at least five years before their planned exit. As stated previously, this gives you time to make needed changes that can increase the value of your company.

However, there are other times and events for which a professional valuation is invaluable. 

During Annual Strategic Planning

Because annual planning is all about making growth strategic decisions that will ultimately determine the future value of your company, these should always be guided by a comprehensive analysis of where your business currently stands.

Upon Receiving an Unsolicited Offer

Having an up-to-date valuation makes it easy to assess whether an offer to buy your business is fair. If it is, the investment banker who performed your business valuation can help you decide if selling at that time makes sense or not.

Before Making Major Business Changes

Understanding your company’s financial position, along with its future growth opportunities and any potential risks is vital before undergoing restructuring, considering a merger or starting the process of securing growth capital from investors.

The Bottom Line on Business Valuations

A professional business valuation is a strategic tool for making data-driven growth decisions, strengthening your company and being fully prepared to meet your exit timeline.

If you’d like to discuss business valuations specific to your personal goals and those you’ve set for your company, let’s talk.

We view this type of conversation as an investment on our part, and we’d be more than happy to discuss your business and future plans in-depth.

The post The Importance of Business Valuation in Exit Planning: A Guide for SME Owners appeared first on Chessiecap.

Not only is a merger and acquisition (M&A) auction a bad idea for some companies seeking to sell, it often doesn’t work. In fact, unlike selling a stock at any price, in M&A you can throw a party only to find that nobody shows up.  

This is particularly true for growth and middle market companies with emerging brands and client bases.

However, there is an alternative technique that we’ve used successfully in special situations over the years, especially when selling to a large strategic buyer or major customer.

Here’s the scenario in which this approach is ideal.

You are a small or growth company and you want or need to sell for all the right reasons. It could be anything from wishing to retire to needing a larger platform in order to win bigger customers. You may know potential buyers, but you don’t know how to approach them without appearing to be in financial trouble or desperate for an exit.

Your buyers have the mentality of large-company corporate development departments. They are willing and built to receive large acquisition opportunities from Goldman Sachs and the rest of Wall Street; they simply can’t pass up a competitor for sale or chance to fill a hole in their product line.

In this scenario we’re talking only about large opportunities, because the acquisition has to move the revenue needle for the acquiring company in order to influence its stock price or create a significant increase in its valuation.

In other words, big companies are not sitting around waiting to receive Confidential Information Memorandums (CIMs) from growth or small revenue companies – no matter how important or revolutionary you believe your company will eventually be to them.

In fact, they get dozens of inquiries each month and the reality is that you’ll never get to first base because your revenues are too small or your banker’s presentation is not compelling to them.

They also know small deals take as much work to close as large deals and, therefore, are not worth their time.

Even if you have a strong relationship with the large company at a product level, supply a component or point solution, or are a key sub-contractor on a major project, Corporate Development doesn’t know you. The CFO who signs the checks doesn’t know you. And the CEO who has promised the board a large acquisition, is not going to risk political capital on an unknown.

Large corporations are not fools. They’re always available for opportunities that will advance their mission and revenues. But they cannot give equal weight to all opportunities, and they certainly do not respond to an auction for a small company.

More instructive is looking at how companies like Microsoft and Salesforce have acquired small companies over the years.

These large players put small companies in their preferred provider system (partner programs) and watch them.

If revenues grow and product connections are inevitable, it becomes better to own the smaller company than outsource the function.

While investment bankers are trained to sell auctions to their future clients, and while we are exceptionally good at facilitating them, even a modified auction (one in which we’re highly selective about who we approach) can be a bad choice for a small company that already knows who should buy it.

Execution: How to Approach a Large Strategic Buyer or Major Customer

The key to selling to a large strategic buyer or major customer is simple: Start early and don’t be for sale!

Go to your targeted potential buyers with an investment proposal or request to participate in a joint development project. Ask your operating executive and/or corporate development contact for an investment in your company in exchange for a minority equity stake. This is particularly useful if you don’t need the money.

If you’re concerned about appearing weak, then the investment should be for something tangible like dedicated product development, company-specific R&D, or new business development.

An immediate advantage of this approach is that you become non-threatening. You are not asking a large company to make an M&A decision in a tight auction timeframe (which, again, is something they overwhelmingly will not do for a small company). Rather, you’re flipping the script and asking for their assistance.

Humans prefer helping over having to make a binary “buy now or miss your chance” decision.

Under these alternative circumstances, they will read your CIM. They will consult with operating leaders at the group or division level. They will take their time and consider the real possibilities of your current and future work together.

Summary

Large companies don’t invest in small companies. they buy them. They do this because they need to be a majority owner to record revenues. While some large organizations do have dedicated venture capital units, this is far less common than it’s been in the past.

So, if you can go to your targeted prospective buyer or buyers with a non-threatening proposal, you avoid a do-or-die decision and can take your time building the relationship beyond the product or division level – and relationships are what get deals done, especially for growth companies.

To take the alternative approach to an M&A auction, you’ll need your investment banking firm to develop compelling presentation materials, make that initial soft approach to the buyer, and construct deal terms and a valuation. After all, you might beat the odds and get that initial investment which then becomes a pathway to an acquisition. A “soft” approach or a non-auction approach may not yield immediate results. But it can get you high-level recognition and give you and your targeted acquirer a roadmap to an eventual transaction.  

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The need for an investment banker was not to organize a process (other than being sure the seller wasn’t leaving money on the table), but to help with the representation in the sale.  

Invariably the effort to get to a closing is as time consuming as seeking out the right buyer in the first place.  

Chessiecap excels at bringing a professional discipline to the sale process which is especially important when the other side has a cadre of lawyers and advisors representing the buyer’s interests.

Founded in 1996 by Dr. Lucie Phillips, IBI is a leading provider of international development consulting services with 28 years of experience working to improve people’s lives around the world. The company specializes in economic growth and governance; monitoring, evaluation, and learning; and stabilization and crisis response.

URC is a globally recognized leader in healthcare quality improvement, committed to building and sustaining resilient health systems by collaborating with partners to implement science-driven, scalable solutions tailored to local needs.

Speaking about the merger Dr. Phillips stated, “URC’s corporate values mirror the way IBI works and serves our clients: respect, integrity, innovation, DEIA, collaboration, accountability, and performance excellence – all based on global insights with local solutions.”

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Most business owners anticipate selling their business at some point. At the same time, they are working hard in the business, they don’t feel ready to start the process or learn what’s involved and may not understand the value of what they’ve built.

So they push off the discussion, focusing on running their business rather than preparing to sell it.

After all, when you haven’t done the type of business planning that will help you understand the implications of selling, it’s easy to assume you’ve got to keep working. You need that income your business provides.

As a result of delaying preparation and the “have to keep working” mindset, many business owners put themselves at a real disadvantage. Especially as the time to sell gets closer or if unforeseen factors force the dissolution of the business unexpectedly.

Interestingly, almost 50% of business owners end up exiting in an unplanned manner thanks to unforeseen factors — a disagreement with a partner, a divorce, disability or personal distress.

This is what I know from working with so many business owners who’ve poured their hearts and souls into running their business: That’s NOT the way to monetize all your hard work.

So how can you be smart about your exit and avoid the pitfalls of failing to plan?

Here’s what you need to do — and why I always tell my clients that exit strategy is your business strategy.

Prepare Now

While entering into a sales process with an interested buyer is seen as the main event, the real work (and I would argue the time during which the value of your business is actually built) happens long before you sign any documents.

Therefore, no matter how far out your exit is, it’s critical to prepare for it now. Your ability to eventually exit your business with a deal that makes you proud and honors all your effort depends on it.

Questions for beginning preparation:

• What are your professional and personal goals as a business owner?
• Do you have an idea of what your business is worth?
• Who is on your team of advisors and do they bring the wide range of skills you need?

Prioritize Enterprise Value Over Income Generation

Too many owners treat their business as their personal piggy bank. That’s a great mindset for supporting yourself and your family, but it’s not so great for eventually achieving an even bigger payoff.

So flip your mindset from running your business to preparing to sell it by focusing on enterprise value rather than income generation.

In other words, build your business in a way that will ensure it has high value to someone else.

A business’s value is based on the strength of its team, products/services, systems, processes, infrastructure and profitability. As you prepare your business for your eventual exit, focus on and invest in these areas.

Questions for assessing and building enterprise value:

• How strong is your team? Can they run the business without you?
• What’s your competitive advantage?
• Do you have intellectual property or proprietary processes?
• Are your processes and systems maximized for efficiency and effectiveness?
• Do you have a goals-based business and financial plan?
• Which financial KPIs need more attention?
• Have you engaged outside advisors to examine all these factors from an objective perspective?

Act On Your Exit Strategy

Once you’re focused on creating enterprise value, start thinking about your exit strategy.

Because exit planning involves answering questions that thoroughly prepare you to sell long before a sale is imminent, the exit planning you do will actually become your business strategy.

It’s a brain twister but once you wrap your mind around the concept, the wisdom of it will be crystal clear.

Think about it like this:

If you want to exit on your terms and with a payoff worthy of all you’ve invested, you must act on your exit strategy from the start. At the least, years not months before you’re ready to exit.

Questions for acting on your exit strategy:

• What is your post-exit vision?
• Who is your ideal buyer?
• Has your advisory team explained your options?
• Have you explored the implications of various scenarios?
• Are you keeping the documentation you’ll need to attract your ideal buyer up to date?

A Final Thought About Preparing To Sell Your Business Now

As a business consultant, one of the very first questions I ask a new client is, “What’s your exit strategy?”

I do this because I know everything I advise and do during the engagement — whether related to strategic and business planning, board effectiveness, organizational design or transition strategy — will impact the owner’s end game and every employees’ future. It’s what’s kept the old saying “start with the end in mind” relevant.

Yet very few business owners are fluent in the complexities and nuances of selling a business.

So as the end comes into view, it can be heartening to know that even the most business savvy owners don’t approach exit planning alone. While this article is intended to shift your mindset, get you thinking about your exit and provide you with a few starting pointers, an entire industry exists to help business owners prepare to sell and walk them through the sales process when its time.

Which means finding the right strategic advisor sooner rather than later is a good idea.

Not only will an early conversation about your exit ease your mind, it can open possibilities you may not have thought were possible for your particular business and your personal post-exit existence.

About Ann Quinn and Quinn Strategy Group

Quinn Strategy Group specializes in strategic and business planning, transition strategy, board effectiveness, and organizational design to help organizations create the meaningful forward motion required to meet critical milestones, achieve goals and ignite success.

The Daily Record recognized the company’s Founder and CEO Ann Quinn as a Top 100 Woman in 2016, 2018 and in 2020 she was inducted into the Daily Record’s prestigious Circle of Excellence. The Baltimore Business Journal recognized her as one of the top 40 metro-area business professionals under the age of 40. You can reach Ann Quinn at ann@quinnstrategygroup.com.

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Well, I’m shocked everyone is so shocked.

What I know is that the 100X investor has performed an analysis using a set of assumptions that justified the thesis that this investment will be a profitable.

Early-stage technology investors are risk-oriented and prepared to lose their investment. However, their analysis has convinced them there’s a better chance they will make money.

So, what justifies 100X?

Answer: A data-informed belief that revenue growth rate (and ultimately profit potential) will be so rapid that, in several years, the valuation paid today will look prescient to the valuation awarded in the future.

In my 45 years as a technology investment banker, I’ve lived through multiple valuation manias. I’ve built the spreadsheets showing investors a valuation is justified. These are never based on a single approach; a single multiple. Rather, the justification is derived from a combination of factors that collectively indicate future performance potential.

If an investor is convinced the “rocket ship” they’re investing in at a valuation of 100X current revenue is equivalent to 1x three-year forward revenue (the revenue it will achieve in the third year after the investment), it absolutely represents the kind of return venture capitalists seek.

Certainly, we know from any number of past examples that increasing annual revenue 100X in three years is rare. And it explains why down rounds occur for companies that overpromised and underdelivered.

But investors have no intention of pissing away their money.

The fact is the 100X Club, rocket ships and unicorns do exist. So, if someone invests what others deem a crazy amount, you can bet they’ve done the math. They have a reason to believe the 100X investment is worth the risk.

Now they may be wrong, or they may exceed their revenue projection, but they have a strong rationale for moving forward.

To understand why a 100X investment decision is not crazy, you’d need to do the math too.

But isn’t that the business and financial media’s job? Not to do the math per se, but to help readers understand the real thinking behind these choices. That would be far more helpful than suggesting venture capitalists are flying on a wing and a prayer.

The post What Some Experts Don’t Understand About 100X Club Investments appeared first on Chessiecap.

For example, I read an article in which a reporter expressed confusion about the price a private company’s employees were offered to sell their shares, stating: “It’s unclear why the company’s valuation has risen more than its per share price.”

This type of statement makes me crazy. Here’s what you need to know to avoid the same confusion.

In the public markets, price per share (last sale price) and fully diluted shares outstanding (disclosed in SEC documents) are known, and the reported valuation is derived using the formula:

Valuation = Price Per Share x Fully Diluted Shares Outstanding

Price per share is what matters because it’s evidence of what any shareholder could have received for their share of stock.

In the private markets, however, there is no full-disclosure requirement and we must rely on incomplete information to determine valuation.

When a valuation is higher than price per share, it may be because the valuation was calculated based on preferred shares. These are typically priced higher than common shares owned by employees.

Quite simply, common shares are not the same as preferred shares.  

Preferred shares have preferences which make them more valuable than common stock, including liquidation preference (i.e., preferred shares get paid back with a calculated return before the common shares receives any payout), preferential voting rights and various other determiners of value.  

This means the valuation of common shares using the price per share they would be worth can be different from the implied valuation of a different price per share of the preferred stock.
 
Another consideration is how many shares are used in the calculation.  

In the public markets, it’s easy to determine because every share is a common share (there are no preferred shares) and its disclosed. But it’s not so simple in the private markets where there’s a capital stack of preferred shares with different preferences. Therefore, the following valuation calculation is used in the private markets:
 
Valuation = Amount of Investment ÷ Percentage Ownership (on an as-converted basis)
 
This generally inflates the valuation because earlier investors – particularly those holding common shares – don’t share in the preferences of the most recent investor. Yet the calculation assumes that ALL shareholders share equally in the valuation.  

Anyone reading about the sale of a company at a fraction of its Unicorn valuation, and in which common shareholders receive nothing, knows how this works.
 
The lesson? Applying a public market valuation methodology to a private company with multiple series of preferred stock results in inaccurate valuation calculations and comparisons. Those entrusted to report on the markets should have enough knowledge and experience to understand why a private company’s valuation might be higher than its per share price – and be willing to explain it.

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When discussing public company valuations, the math is relatively easy. There is a price per share and a known number of shares owned by the shareholders. Multiply them together and you have the equity value of the company.

For actively traded companies, this is a reasonable representation of what the company is worth since any shareholder could sell their shares for that price thereby receiving their piece of that valuation.

However, this methodology applied to private companies with multiple classes of preferred shares with various rights and preferences that differ from each other wrongly implies that each share is worth the same as the shares sold in the last round.

One of the most important things an IPO accomplishes is simplifying the capital structure into (generally) a single common stock. The several rounds of convertible preferred stock go through a mandatory conversion into common stock (the same stock that the IPO investor will receive) on the basis of the preferences of each preferred round.

Early in my investment banking career I learned that prospectuses are written “as if” the IPO has been completed. In other words, the prospectus details what the company’s capitalization will be immediately upon completion of the IPO, not what existed just prior including all the conversions of the various preferred stocks.

It’s “as if” the preferred stocks never existed. The IPO investor doesn’t need to know what the terms of the now nonexistent preferred stocks were in order to make an informed investment decision.

So why is this important?

When a Unicorn goes public, reporters tend to imply that the most recent investors (who invested at lofty valuations) are being hurt (losing money) because of the substantial decline in the value at which the underwriters are proposing to price the IPO relative to the valuation at the time of their investment.

While it’s true a lower valuation means the shareholders in aggregate have something that is worth less, it is not true that all the classes of shareholders share pro rata in the decline in valuation.

Most of the fundraising rounds that result in Unicorn status have liquidation preferences, which include provisions protecting against the IPO price not equaling or exceeding the price the investor paid.

Although it’s difficult to find out, and is not a required disclosure in the prospectus, the preferred investor usually builds in a minimum return for itself by having liquidation preferences the IPO triggers.

Although the mechanics may differ, here’s an example I’m intimately familiar with:

The new investor agrees to a seemingly extraordinary valuation where financial professionals wonder how the investor ever expects to make an adequate return on its investment. In this case, the investor built in a guarantee that it would receive a return of 3x on its investment. Normally the number of preferred shares an investor receives is equal to the investment divided by the price per share paid (valuation divided by fully-diluted shares). Each share of preferred stock has the right to be converted into common stock on a 1-to-1 basis.

However, the liquidation preference in this case guaranteed that the value of the common stock the investor would receive at the time of the forced IPO conversion would be worth not less than 3x the investment. Let’s say the IPO is done at a valuation exactly equal to the valuation at which the preferred investor bought his shares. Instead of receiving one share of common for each share of preferred, the conversion ratio is adjusted so that each preferred share receives three shares of common.

While in theory the “flat round” seemingly means everyone has maintained their value; in reality, the preferred has increased the value of what it owns at the expense of all the other shareholders.

Now apply this same technique to each of five or more rounds of preferred, each with its own liquidation preference applied in order of priority of earlier rounds of investment.

The consequences are further magnified in a “down round” where the valuation is cut in half. Instead of receiving three common shares for each share of preferred, they receive six common shares in order to receive the equivalent of 3x their investment in common stock value.

This increases the percentage of fully-diluted common shares the former preferred shareholders own and decreases the percentage owned by the original common shareholders.

The fall in valuation is borne by the earlier investors, not the later preferred investment rounds in this more complex example.

The point is: Consequences of a down round or reduction in the IPO valuation are NOT shared equally across all investors.

In fact, it’s likely the investors who paid the highest prices/valuations are still making a substantial return on their investment while the earlier rounds (especially the founders) are absorbing most of the decline in value.

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With the stock market experiencing extreme volatility, I think of the old Wall Street quote used by traders: “Never catch a falling knife.” Quotes from traders are known for being blunt, graphic and a bit rude. No one can know where the bottom of this market is, except in retrospect.

When you have witnessed enough of them, you learn that “recession” is synonymous with “unpredictable.” There are always a few lucky souls who predict a recession and act on it. But like victims of the proverbial baseball bat, 99.99% of us never see it coming until it is too late.

A major reason for that unpredictability is the fact that each recession has a different origin. There are almost no lessons to be learned from scanning the horizon. The oil price shock and credit distortions of 1990-1991. The tech and accounting scandals of 2000. The housing and banking debacles from the Great Recession of 2008-2009. And now in 2020, an exogenous recession as a microscopic virus sweeps through the world.

A second defining characteristic of a recession is that we cannot know how long it will last. When people don’t go to work, don’t travel, don’t eat out and don’t go to stores, then we might be in a recession. When those activities will restart and when the economy will return to a semblance of normal is anyone’s guess. And guessing it will be.

For those of you who were considering a sale of your company before COVID-19 or are considering a strategy to sell on the other side of this economic shutdown, the recession may be guesswork, but what happens during it should not be. There are valid observations from past downturns that likely will be operative in this one.

Mergers and Acquisitions

In the accompanying chart, 1990 was a record year for numbers of M&A transactions completed in the United States. In the recession year of 1991, the number of transactions dropped a mere 5% but the total value of those transactions dropped 30% from the year before. In the recession of 2001, the number of deals done dropped 31% from 14,114 to 9,652, but again the volume or total dollar of the transactions dropped even more at 48.6%. The same was true for the 2008-2009 Great Recession. In each case, there were plenty of transactions completed in a recession year, but the dollar volume dropped significantly.

The message is simple enough. The big headline deals that typically appear at the end of an economic expansion disappear or go on hold. (Xerox/HP, Mylan/Upjohn, Willis Towers Watson/Miller divestiture, Woodward/Hexcel.) Average deal size drops. But thousands upon thousands of small and middle market deals continue to get done.

Pricing

This is not to say that prices and multiples paid remain at the same level they were before the recession.

The psychology of multiples, of what you will take as a seller or of what a buyer will pay, is complicated. For most of a company’s life, these two desires do not intersect.

Imagine that the economy is going gangbusters. Your business is growing its revenues at 15 percent a year, making $1 million in EBITDA this year. Along comes a buyer who offers you six times (6X) EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization or “cash flow”) or $6 million. In a no-growth scenario, this is effectively saying that someone will give you six years of profits up front. But you are growing rapidly, and you realize if you keep the business, you can bank cumulatively $8.7 million of profits in those six years. Selling now seems like a giveaway of $2.7 million to the buyer. So, you will not sell until the buyer comes back with at least an eight times (8X) multiple of EBITDA.

Now imagine this next scenario. We are coming out of a recession. Your 15% revenue growth has shrunk to zero. You are struggling to maintain your $1 million of cash flow. There is a lot of uncertainty in the market, and you cannot predict when the market for your goods and services will start growing again. Along comes a buyer who offers you five times (5X) your EBITDA. As explained, you are effectively getting five years of no-growth profit up front. You can forgo five more years of market, employee, product, and other risks. With this second lower offer, you can put that $5 million safely into U.S. Treasuries, sleep well at night, and maybe look for a second home in Florida. A year earlier, you rejected a 6X purchase price. Now, a 5X purchase price has a lot of merit.

Surf’s Up

There is a catch to this scenario. When multiples come down after a recession, sellers still have imprinted in their minds the pre-recession high multiples. There is often a lag time before sellers can adjust to the new pricing, the new risk/reward equation. Those who broker mergers and acquisitions (investment bankers) know that transactions often occur when both the buyer and the seller are equally unhappy.

The buyer pays a little more than it wants to, and the seller takes a little less than it expected. With some compromises and a re-imaging of the current market, both parties walk away only moderately pleased with the pricing. That is the nature of M&A. Deals will happen thousands of times over in the coming year. And many a seller will finally buy that home on the beach.

As printed in Citybizlist, May 20, 2020

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We know from the history of recessions that thousands of mergers and acquisition (M&A) transactions occur each year, even in an economic downturn. In this strange coronavirus recession, who is going to buy your business and how much will they pay?

Strategic Versus Financial Buyer

For most of the forty years since the creation of the modern LBO in the early 1980s, Strategic buyers have paid more for target companies than financial buyers. Strategic buyers are mature corporations, often pioneers and leaders in their fields. They have established products and services that can swell cash on the balance sheet. Cisco Systems and Oracle acquired scores of acquisitions in the late 1990s and were key drivers of the Tech Boom, often cashing out private equity and venture funds.

Strategic buyers not only had cash, they had the advantage of adding a target’s business to their own business, thus creating “synergies.” Synergies are a rationale used by all buyers to pay more for a company than the financial numbers would dictate.

[I once knew a chief financial officer who distained the term “synergies.” “One plus one never equals three,” he used to say. Whether synergies are real or magical thinking is a topic for another day. The point is that if a buyer is willing to pay for synergies, a seller is happy to accept the largesse.]

The original Financial buyers were Leverage Buyout (LBO) funds, which were radically different creatures than they are today. LBOs were developed in an era of expensive debt and were constrained by their very name “leverage,” which means debt or bank financing. The traditional LBO fund brought a mix of its own equity to the table as well as cash obtained from debt financing. They rose to power in the 1980s with the help of firms like Drexel Burnham Lambert and were epitomized by names such as KKR, Clayton Dubilier & Rice, and Welsh Carson. Today, the term “Private Equity” or “PE fund” is used as a full substitute for LBO firms. “Private Equity” has a kinder, gentler ring to it.

Because of leverage, there was a calculable limit to what an LBO firm could pay for a business. In a fair fight, if the Strategic buyer really wanted the target company, the Strategic buyer could stretch the pricing, and the Financial buyer would always lose. Often, Financial buyers would refuse to be part of an auction in which they thought a Strategic buyer would be bidding. It was a guaranteed defeat and waste of time. In the Old World Order, Financial buyers provided the pricing floor for the market. Strategic buyers were the sought-after ceiling.

The Rise of Private Equity

In the last decade since the Great Recession of 2008, the growth of money going into Private Equity funds has been phenomenal. In the chart below, you see the steady rise of deals completed since 2008, totaling over $800 billion or almost 4 times the low in 2009. Alongside this growth in capital invested has been a sustained period of historically low interest rates. Low interest rates reduce the cost of debt and allow the PE firms to pay higher prices.

With so much money parked in Private Equity and fueled by low interest rates, the old rules have gone out the window. The line between strategic and financial buyers is no longer a bright one. The rise of Private Equity has created Financial firms that can act like Strategic buyers. A handful of them including Blackstone (NYSE:BX), Apollo (NYSE:APO), Carlyle (NYSE:CG) and KKR (NYSE: KKR) are now major publicly traded companies. Financial buyers routinely compete with and outbid Strategic buyers.

US PE Deal Activity: 2008-2019

Too much money, too many PE funds, and not enough deals. This translates into competition and competition translates into higher and higher multiples paid for companies. In recent years, PE professionals have railed against the multiples they have had to pay to win businesses. Dog-eat-dog. One PE fund would outbid the next, with no one to blame but themselves.

In its “Global Private Equity Report 2020,” Bain & Company reports for 2019 that “More than 55% of US buyout deals had a multiple above 11x.” This means a purchase price that was an astounding 11 times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization—or cash flow). Even for small transactions, PE buyers have complained bitterly about having to pay up to 9 times (9X) EBITDA or more in order to win a deal.

In the early years of the LBO, if you paid 5 times (5X) EBITDA, you were at the high end of the range. An 11X multiple means that if a purchased company does not grow, an investor will have to wait 11 years (assuming no taxes) just to get its money back. This is la-la land pricing. It puts tremendous pressure on purchased companies to immediately grow revenues and profits—and certainly not to run into a recession.

The Covid-19 Crash

As soon as the stock market crashed in February of 2020, we heard the rumblings of repricing of deals and a general sigh of relief throughout the world of Private Equity. Multiples paid for businesses would have to come down to rational levels. Pricing power would shift from the seller to the PE buyer.

A reset or reduction of multiples paid is normal and expected in a recession. A recession cures economic imbalances, brings down over-valued sectors, and generally levels the playing field. But with this COVID19 recession, something is very different. This recession hit like an asteroid in the middle of a picnic. We were experiencing one of the longest economic expansions in history. Most sectors of the economy were doing just fine. None seemed to be overheated. Unemployment was low. Growth was steady. When COVID-19 hit, it did not feel like we had earned a traditional recession.

Recessions have typically culled the herd of Private Equity firms, punishing the foolish and laying waste to poorly constructed leveraged transactions. Those firms with portfolios full of over-priced deals in struggling industries fall by the wayside. With fewer PE firms, competition is reduced. Multiples paid come down. Again, supply and demand rule.

The biggest unknown in this coronavirus recession is how much damage will be done to PE firms and their thousands of portfolio companies. As I write this, associates and analysts in PE firms around the world are burning the midnight oil trying to determine if their firms’ portfolio companies can make it through mitigation to a re-start of the economy. Portfolios full of restaurants and retailers are obviously under pressure. But since most portfolio companies and most sectors of the economy were healthy before the asteroid hit, no one knows yet what the effect will be on competition and pricing.

The Illusive Overhang

On paper, there remains an immense amount of money committed to Private Equity. Some funds, particularly ones that have just raised money, are advertising that they are open for business and ready to invest. Is this just bravado, and will these funds still pay high multiples when the deals finally close?

In the chart below, you can see what is called the capital “overhang,” the amount of money that was committed to Private Equity but was not yet invested as of last year. (Also called “dry powder.”) At midyear 2019, this overhang was a whopping, estimated $740 billion. The yearly increase in multiples paid for businesses tracks this yearly increase in the overhang.

The big unanswered question that ultimately affects pricing is: “In this recession, how much damage will be done to the overhang?” The overhang can shrink quickly for many reasons, including balky investors. But the main and obvious reason is if PE funds are forced to divert excess cash into struggling portfolio companies.

The Likely Future

The big change coming out of a recession will be the initial dependence of sellers on Strategic buyers. In the early months, advantage should return, for the first time in many years, to corporate acquirers.

Strategic buyers will continue to have reasons to add products and services in order to grow. In many growth industries such as software, cloud, edtech, health care, security, green, and biotech, the multiples paid may remain high. Strategic buyers in industries that have weathered the COVID-19 storm well (such as many tech sectors) will have plenty of cash and can still justify prices based on need or synergies.

Our prediction is that many Financial buyers will be hesitant to act. Many will be preoccupied with steading their own portfolios. Many will look cautiously on target projections in a slowed down economy. And many will be looking for that hoped for break in the market, taking the measure of the market for lower multiples.

If the recession is short and if Private Equity portfolios of companies do not suffer major losses and if debt remains available and low-cost, then the same dynamic of too much money chasing too few deals will still be operative. It may prove impossible for Private Equity to hold to any new low pricing discipline. Multiples paid for businesses can creep quickly back to pre-recession levels, and PE firms will be back competing toe-to-toe with Strategic buyers.

Coming out of this coronavirus recession, low-growth, low-profitability businesses in everyday industries like distribution or manufacturing will suffer the most. If you are a seller of such a business, there is no sugarcoating how difficult it may be to find a good buyer at a price that interests you. But our original observation may bring you some comfort. Thousands of transactions occur each and every year, regardless of the health of the underlying economy. Yours could be one of them.

As printed in Citybizlist, June 3, 2020

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