While working with business owners one of the issues most often pondered is “When Should I Sell My Business?” On a personal level the answer may be:
- when your heart is no longer into it
- when you decide it will take new blood or capital to get to the next level
- when you reach an age when you are ready to retire
- or any of a host of personal reasons
While any of the above may be good answers, one principal objective of the investment banker should be to help business owners time an exit so as to maximize their value in a transaction. Since the last recession officially ended in June 2009, we are now talking to many business owners who have two or three years of double digit earnings growth. Many of these people are baby boomers thinking about an exit strategy and believe their business has at least one more year of solid growth. They also do not want to get stuck fighting their way through another downturn. So, the real question is:
“Do I sell today or bet on another year of growth?”
The short answer is that buyer expectations drive value and one slow year deflates expectations very quickly. Buyers are investing in expected future earnings and historical earnings and growth rates are the baseline for creating the expectations. Discounted Cash Flow (“DCF”) valuation models are the tool most frequently used to quantify future value. The following example illustrates the importance of selling when expectations are high.
Assumptions – Company for Sale:
- Revenues and earnings have been growing by 10% annually, outlook is good.
- A buyer can borrow 30% of the purchase price based on the company’s cash flow and balance sheet. Weighted average cost of capital is approximately 16.8%.
- The fiscal year just completed produced operating income of $1,000,000.
Scenario 2 – Grow for 1 more year, then sell
- The economy slows and operating income grows by 5% to $1,050,000.
- Buyer’s DCF model assumes growth continues at 5% for 5 years and then 3% in perpetuity.
The discounted cash flow valuation is $4.9 M.
Selling with a strong growth outlook (scenario 1), versus selling later with a larger profit but a weaker growth outlook (scenario 2), almost always results in a higher transaction value. In the example, the Seller would have achieved a $1.3M higher valuation had he sold today with $1.0M of profit and growth rates of 10% (scenario 1), versus selling a year later with the higher profit of $1.05M but a lower growth rate of 5%. (scenario 2).
Both scenarios involve buyers with reasonable expectations based on recent operating histories, but higher earnings are almost never an adequate substitute for faster and/or more predictable sustainable growth.
There are many factors that are considered when a buyer values a company. Return on investment as quantified in a Discounted Cash Flow analysis, which discounts future expected earnings, is often a major consideration. That stated, our answer to the question of “when to sell,” is the following:
Sell when you have strong growth. Do not underestimate the risks of trying to add another dollar of profit. If you sincerely believe that there will be strong growth for a few more years, negotiate an earn-out or retain some equity so that you can participate in the upside, after you have put some money in the bank and mitigated the potential risk of a slow down.
As a final consideration, we like to remind clients to plan on one to three years from the time you decide to sell until the time you are free to sit on a beach. This includes six to 12 months to complete a transaction and one to three years for a typical employment transition and/or earn-out.
Note: There are many factors that are considered when an investment banker or a prospective buyer estimates the value of a company. Discounted cash flow models are a frequently used tool and involve more variables than could be reasonably factored into the above illustration. Buyers who are seeking to satisfy strategic objectives through an acquisition will frequently offer valuations that are above what could be justified by DCF modeling. Only the market can determine what a company is truly worth.
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