The critical first step in selling a business is to properly analyze and value it to establish a price. In the case of an undervaluation, when the business is sold the result is obvious; the owner receives less. Conversely, businesses that are overvalued and overpriced usually do not sell. The reason for this is because of the principle of alternative investments, which states that rational buyers will act on some alternative business investment where they expect to earn a higher return on their invested capital. Setting a reasonable price is critical to a successful deal. Buyers won’t spend time pursuing overpriced opportunities.
All business valuations are based upon the expectation of future economic benefit. An investor, appraiser and transaction broker (investment banker, M&A advisors, et al) looks at historic earnings or cash flows (usually 5-years or more if available) along with other factors such as the current economic environment and outlook, industry trends and outlook, and internal business factors. From this analysis, when the earnings stream is expected to grow at a fairly constant rate over time, the valuator estimates the next year’s earnings stream, which is then converted into value using a risk-adjusted rate of return; as a devisor (capitalization rate) or multiple (1/capitalization rate) derived from market sources for similar investments. Note that the earnings stream is forecasted in harmony with the basic premise of value — the “future expectation of economic benefit.”
In addition to this critical valuation piece, the transaction broker creates competition in the market, or at least the perception thereof.
There are two categories of buyers: Financial Buyers, which include the typical individual owner-operator or investor group who usually pay fair market value (FMV); and Strategic Buyers, which is a company that has a specific business reason to purchase and has synergies with that business. Because strategic buyers get more earnings and therefore value out of an acquisition than the FMV of the target company, they may be willing to pay a premium price.
The existence of competition in the market, among financial or strategic buyers, usually results in the ultimate price paid being higher than if no competition exists.
In my 20 years of M&A experience, I have found that getting strategic buyers to pay more than FMV when there is no competition is difficult. When a business is marketed by a transaction broker, competition normally drives the purchase price upward, much like an auction environment.