The Three Characteristics of Marketable Companies
Before contemplating a sell-side transaction, shareholders must first consider their company’s degree of marketability.
In general, three characteristics influence how ready an organization is for an optimal change in ownership. Companies exhibiting these attributes can be marketed more smoothly and are more likely to earn market multiples. In some cases, such companies can command healthy premiums if they can demonstrate that they are best in class.
Characteristics #1 — Institutional Strength and Resiliency
Ask yourself what would happen if you decided to not show up to work. Would your business face operational disruptions? Would suppliers raise their prices or wish to stop working with the company? Would your customers buy less or stop buying altogether? Would the quality of your products or services fall? Would the company lose significant intellectual property that the owners hold in their heads?
The more you answer “yes” to these questions, the more of the value of company is tethered to its existing owners. Since the purpose of a transaction is to transfer this value to the buyer in exchange for cash and/or other benefits, the more value is tied with the current owner, the less valuable the corporate entity becomes. Should this concentration of critical know-how and mastery of processes be excessive, the transaction may not make sense to buyers at all, thus making the company very difficult to sell. In contrast, companies with high levels of institutional strength avoid such value leakage and are more attractive to a wider universe of buyers.
This problem is more widespread than you might think – and it does not necessarily only apply to the smaller enterprises. As a business grows, corporate infrastructure may often lag behind. How many companies with 300 employees or more have an owner that originates the multi-million-dollar deals or services key relationships? The answer is far more than you would think.
Characteristic #2 — Exposure to Quantifiable Risks
All M&A transactions expose buyers to various risks. Some customers may decide to move their business after the company is sold. Some suppliers may terminate their relationships. Key employees may leave. Deal synergies may not materialize. Costs may prove difficult to cut. The integration process can become protracted, more expensive, and/or can fail altogether.
Buyers not only anticipate these risks, but also quantify them to the extent possible, and, as such they price and structure deals accordingly.
There are two kinds of risks. The risks we can reasonably quantify and those that we cannot. Any competent analyst can estimate the impact on enterprise value if the target company loses its biggest customer or if a critical supplier raises prices. Similarly, analysts can quantify the disruptions in performance resulting from the loss of a critical employee. When a buyer has a clear picture of the risks inherent in the transaction and can quantify them within a reasonable range, they can adjust an offer accordingly.
Without an ability to quantify risks, a buyer can’t price them – making it hard for any prudent decision maker to consummate a deal. Examples of potentially unquantifiable, existential risks can include a major on-going lawsuit, a pending regulatory investigation, or past violations of contractual commitments, etc.
The key to remember is not that, on their own, these diligence concerns jeopardize the deal. Instead, their unknown magnitude creates a large and irreconcilable valuation gap between buyer and seller. In this case, the seller faces a choice between accepting the absolute worst-case scenario valuation or walking away completely. At the same time, should the worst-case scenario materialize, the buyer’s transaction rationale evaporates, making the deal unpalatable.
Characteristics #3 — Competitive Performance Indicators
A company underperforming its peers will face a valuation discount. If a business cannot demonstrate performance at the level of its peers, then it can not and will not earn a market valuation. Would you pay a market price for a less than market-quality product?
Each industry has certain key metrics that are common across market participants. For example, brick-and-mortar retailers will use same-store sales. Software-as-a-Service companies track customer retention, lifetime user value, churn-rate, and customer acquisition costs. A technology hardware company may use gross margins. Hotels will use RevPAR amongst other metrics. Thus, depending on your industry, you will focus on different metrics to monitor both absolute and relative performance.
A company whose indicators are close to the market average is well positioned to earn at least a market average valuation multiple (should all other items check the box). In contrast, a company that is underperforming across key metrics, will likely face discounts. Conversely, a company excelling across the board may earn a slight premium due to its unique “best-in-class” positioning.
Before starting any sell-side process, objectively (looking in the mirror with a critical eye is tough!) evaluate your company and answer the following questions:
- Would the company be negatively affected if you would walk away?
- Are the risks to the company so undefined and so hard to quantify that no amount of diligence, analysis, or re-pricing of the deal can reconcile the valuation gap between buyer and seller?
- Does the company fail to meet market averages across a set of critical performance indicators for its industry and sector?
If you can confidently and objectively answer “no” to all these three key questions, then your company is likely well positioned to face buyers.
If the answer is “yes” to one or more of these questions, that does not necessarily mean that the company is not sellable or has no value — it simply means that doing a deal will be far more difficult and that the company may receive a discounted valuation, perhaps significantly so. In other words, it means you have some work to do to prepare for an optimal exit.