Avoiding Valuation Kabuki Theater
By Scott Winship, Managing Director
Middle market M&A transactions, particularly those that involve family-owned or entrepreneur-owned businesses, are replete with complex nuances that do not (typically) present themselves in up-market, institutional transactions. The emotional content of mid-market transactions is often coupled with a relative lack of “deal sophistication” on the part of the business owner(s), which can manifest in a healthy amount of confusion, as the deal is more than likely to be the first and the last deal they ever do. This confusion is often exacerbated when business owners solicit opinions from their family and friends, where viewpoints are plentiful, but contemporary and acute experience is frequently limited and/or materially misguided.
Unsurprisingly, in the litany of critical transactional components, valuation is the element that comes immediately to the forefront in early discussions between potential sellers and investment bankers. More often than not, the first question asked is: “What is my company worth?” It’s not unusual for that question to be followed by a statement of opinion before the banker gets the first word out in response. The fact of the matter is that valuation is extremely nuanced, and involves dozens of components that must be analyzed and put into dimension before any credible view can be offered. An abbreviated list of key analysis points include: top and bottom line trending; gross margin stability and expansion; customer and vendor concentration; channel dynamics and disruptions; IP considerations; management stability; competitive dynamics; capital intensity; legal, regulatory and environmental exposure; corporate infrastructure integrity and leveragability; systems and reporting depth; labor relations; and debt and equity financing availability.
Clearly, any good sector banker will have plenty of relevant precedents to draw on as it relates to deal comparables. However, it is critical for sellers to appreciate that no two situations are ever the same, and that reliance on generalizations can be perilous, if not fatal, in terms of appropriately setting expectations. Moreover, the absolute sophistication of the professional buyer universe ensures a DNA-level drill-down into every single pertinent aspect of risk and opportunity in the formation and support of a valuation view. Therefore, dismissing or not proactively addressing the challenges that exist inside every good company will assuredly result in a walk down the primrose path if expectations and reality are widely divergent at the outset.
Valuation discussions between sellers and advisors must involve honest dialogue and a rich sharing of financial and operational information from which thoughtful analysis and highly informed views result. Once that occurs, a realistic baseline is determined along with specific valuation buoyancy elements that can be generated through: 1) proper positioning, 2) the execution of a highly tailored process, and 3) the generation of palpable competition amongst buyers. Ultimately, there is a significant artistic, intangible influence in the valuation complex, whereby deep experience and practiced judgment prove to be more reliable barometers of likely outcomes than a point-in-time math equation in a pitchbook.
Make no mistake about it, investment bankers are close to the top of the capitalist spectrum and directly incentivized to achieve the highest and best outcome for their clients. However, that outcome rarely materializes if a misalignment on valuation takes place at the starting line – be it on the part of the business owner or the advisor. As such, it is critical that any business owner contemplating a sale be appropriately skeptical of “country club advisory,” sprint from any investment banker that provides a valuation five minutes into an initial meeting, and actively seek out advisors that will dedicate the time and effort to fully un-pack your company in detailed analysis before hands shake and engagement letters are signed.