If we could only predict the future! What geniuses we would be.
Sadly, far too many entrepreneurs fall into this trap as they consider the timing of their exit strategy. It seems that the unbridled optimism that business owners must have (who in their right mind would risk everything to create a business not knowing the future) often works to their detriment when it comes to exit planning.
Too often we hear: I will sell when the time is right.
When we ask “When will the time be right?”, we are told, I just will know.
The reality is far too many are waiting for the perfect alignment of stars, moons, and tides before starting their exit process. Since it takes 9-18 months to actually close an optimal transaction with an ideal buyer, waiting until the timing is perfect is sadly often not the best plan.
One thing to consider is this: The cost of capital to acquire companies is driven by interest rates. Simply put, the cheaper it is to finance an acquisition, the more buyers will pay (all things being equal). Keep in mind that professional buyers, the kind that you want to deal with, have many options they can pursue with their money. The least risky option is simply parking it in U.S. Treasuries since they are risk-free, require no work and are backed by the full faith and credit of the U.S. government.
So let’s assume that you are negotiating with a buyer who has his/her funds earning 2% (in today’s market, for example) and is pleased with that return. How much would this buyer need in ROI (return on investment) to acquire your company?
Let’s assume that they would need 5x (*see note below) the risk-free rate because of the work and risk associated with your investment, so 10%. If your company is generating $300K in pre-tax profit, that means they could pay you $3 million for your business and earn their ROI of 10% going forward.
What a deal! You get out from under the risk and hard work of running your business and exit the company with $3 million. But sadly, at the 11th hour you decide, “Well, I am going to time this to get a better deal. I’ll spend time growing my business and exit in two years or so after I have radically expanded this company.” So you walk away from this offer.
Two years later, you have grown your earnings to $450K, which is fantastic! You are now ready to put your exit strategy into action.
However, U.S. Treasuries are now generating 3% for your original buyer. Again, they are earning this 3% risk-free, work-free, and with no hassle for them. So, assuming they would still need 5x the risk-free rate (and assuming that they are still interested in acquiring your company), their ROI now is 15%, not 10%.
How much would they pay you two years later for your $450K in earnings? Sadly, because the cost of capital has increased over the two-year window, they will still only pay you $3 million, because an ROI of 15% (again 5x the risk-free rate) on earnings of $450K still generates a $3 million offer.
This means you have taken on two years of serious risk and hard work (and two years of your life that you will never recover) to get the same deal you would have had two years earlier.
Does that make sense?
But this is just one example of how waiting, growing, and hoping can hurt your bank account because ultimately with any buyer, interest rates play a key role.
Why are company valuations so high in today’s market? Because despite recent Fed increases, interest rates remain at historic lows. But where are rates heading? The Fed has already indicated that they plan further increases this year and several next year. What will that do to valuations overall?
Yes, you guessed it: Drive them lower. Where will interest rates be in three years? How about five? What will that mean to your company’s market value? Even if you grow your company dramatically over this time frame, you could end up with substantially less from your exit strategy as our example above shows.
And interest rates are simply one part of the valuation equation that buyers use to justify their offers. What happens if the supply of companies for sale dramatically increases, which is predicted to occur over the next dozen years or so as the 60% of all privately held baby boomer business owners retire. The laws of supply and demand will come into play and will dramatically impact business valuations.
We are now back to the original statement: I will sell when the time is right. When we ask, when will the time be right? We are told, I just will know.
I would suggest that the time is now, especially as it relates to the key component of most transactions – interest rates.
As we have learned, don’t let other issues that may not mean as much color your thinking and block your mind from the reality that this is the strongest seller’s market we have seen in decades. The low cost of capital is driving buyers to be very aggressive in terms of company valuations overall.
Since we realize that the process of exiting a company can be quite complex and emotional, we have created exit planning conferences designed to help you understand how to eventually leave your business for maximum value. Attending one will help you gain significant knowledge about successfully exiting and place you in a better position to achieve your financial goals.
To learn more about our educational conferences and the services Generational Equity provides, use the following links:
And even if you don’t attend one of our conferences, do some research on the cost of capital and its impact on company valuations. That way you can understand how it influences valuations overall, and your company’s in particular.
By Carl Doerksen, Director of Corporate Development at Generational Equity.
© 2017 Generational Equity, LLC. All Rights Reserved.
*Note: I am using 5x the risk-free rate simply to make the math easy to understand. In reality, most buyers will require a much higher ROI for investing in a privately held company given the significant risk and unknowns involved in making the acquisition.
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