Is the amount that a buyer will someday pay directly related to company profitability? Yes and no. The amount that the buyer will pay is a direct corollary of two factors:
- The buyer’s estimate of what profit HE will be able to produce by operating your company, and
- The buyer’s perception of the likelihood of competition beating his offer.
Except in cases of newly emerging proprietary technology, the buyer’s estimate of profit potential is almost always linked strongly to history. Of that history, clearly the most important element is the most recent time period. Nevertheless, ideally in preparing for sale, you would like to build a solid and relatively stable historical picture of growth – both in sales and in profitability.
The profit piece of the picture can and always will, from the buyer’s viewpoint, take into account ownership quirks. For example, if the owner takes zero salary but works sixty hours per week, the buyer will recognize that a replacement cost will be required to pay someone else to do the job that the owner is now doing. Alternately, if the owner works ten hours per week but pays himself an enormous salary, that salary clearly looks to be, at least in large part, owner return on equity. The buyer will add such salary back to get the true stand-alone profit picture.
Buyers will thus focus upon the “owner-neutralized” historical profits from operations. Buyers also will view the company with an eye to what they believe they can make from it. Thus, if the seller is carrying ten expensive administrative people which the buyer could do without, that will be built into the buyer’s analysis. If the buyer thinks he can double sales of the seller in a heartbeat by expanding the seller’s product offering to his own existing customer base, that too, will be a factor.
There is one other peculiarity to this concept of profit impact on pricing that is worth mentioning. Generally, as any market analyst will tell you regarding price-point relations top earnings, the P/E relation (price to earnings) doesn’t mean anything when there is no “E”. However, in the sale of a business as a whole, there are exceptions to this fundamental investment wisdom. Although profitability invariably is a powerful determinant of business pricing, there are situations where even loss operations can produce aggressive competitive pricing among buyers.
We once sold a $30 million plastics company with consistent losses for the past three years. The company had heavy debt levels, and their banker sponsored a buyer who offered to assume the debts and pay $500,000 for the company. In spite of the loss environment, we were confident that competition would drive price to at least a few million dollars. We encouraged the seller to hold on, to resist the pressure from his bankers, and to let us talk with other prospective buyers. In three months, the company was sold for $3.5 million in cash. There was no multiple of earnings justification and no substantive market value of assets to aid in the value determination. The price came entirely from raw competitive interest.
Poorly run businesses with low or zero profitability, if they show strong volumes and/or good gross margin, may still be perceived well. If a clear and viable case can be made to buyers that the earnings potential is strong, even where history is weak, buyers will compete for the purchase. Once again though, their appetite and their aggressiveness in pricing will depend on their belief that such competitive pricing is necessary to win the deal.