Business Valuation - Transaction Advisory - Ownership Transition - Business Listings

Financial Consulting

Pepperdine Annual Cost of Capital Survey

By Maurie Cashman

The Pepperdine Annual Cost of Capital is a survey that I have participated in for several years. It contains interesting information about the expectations and and experience of market participants in private company transactions from various perspectives. What follows are selections from the current survey and comments.

Respondents believe labor availability is the most important current issue facing privately-held businesses. Inflation will be the most important emerging issue. This was consistent across most segments.

Issues Facing Private Business – Survey

Government regulation and taxes was rated the highest concern for those of us who do business valuation. This may be significant as those of us focused on the effects of the new tax bill may have more insight into this issue than others in the survey. The new tax law has several impacts beyond just the lowered tax rates for corporations that will have a significant impact, particularly on managing the tax impact of a business transition.

Average Number of Months to Close One Deal

The top three reasons for deals not closing were: valuation gap in pricing (36%), unreasonable seller or buyer demand (20%) and no market for business (11%). This is significant. It is important that you are working with qualified professionals in assessing the value of the business. Even then, the value of your business is what a willing buyer will pay for it and what you would agree to sell it for. It is easy to tell an owner what he wants to hear – that his business is worth a ton of money. The brokerage community is known for this – in many cases trained to do it. It is much harder to tell an owner what his business is really worth and to honestly prepare here for the reality of a sale.

Reasons for Business Sales Engagements Not Transacting

Of those transactions that didn’t close due to a valuation gap in pricing, approximately 69% had a valuation gap in pricing between 11% and 30%. Note: this graph can be confusing. The red segment, for example, means that 35% of valuation gaps were between 11% and 20%.

This can be devastating if you are an owner heading into a negotiation to sell your business. If you are unrealistic about the value of your business you are inviting a buyer to be just as unrealistic about an offer, it you can get them to make an offer at all. Once the buyer finds out that you will give significant concessions on price, they will likely be much more aggressive on other terms. Better to go into negotiations with a defendable price.

Valuation Gap in Pricing for Transactions That Didn’t Close

Approximately 56% of closed business sales transactions over the past 12 months involved strategic buyers.

Percent of Transactions Involved Strategic and Financial Buyers

Approximately 22% of respondents did not witness any premium paid by strategic buyers, while 58% saw premiums between 1% and 20%. The strategic buyer is likely your best bet as they have more reasons to want to integrate your operation into theirs. They are building a long-term business model and know they only have so many opportunities to make strategic acquisitions. And they are willing to pay to get it.

Premium Paid by Strategic Buyers Relative to Financial Buyers

BROKERS

Approximately 66% of respondents indicated it was ‘buyer’s market’ for deals valued under $500 thousand, whereas only 21% of respondents indicated it was ‘buyer’s market’ for deals valued between $5 million and $50 million. This indicates a significant opportunity for sellers that may not last. With the prospect of increasing inflation and corresponding increases in interest rates, labor shortages, uncertainties in government policies and the strong economy we may be in a goldilocks period where the environment for selling a business is just right.

Was It Buyer’s or Seller’s Market in the Last 3 Months?

Strategic buyers dominate in larger purchases, followed by PE firms. This makes sense as most strategic or private equity buyers want to focus on larger deals for two reasons:

  1. The acquisition is large enough to move the financial needle on the resulting entity;
  2. The acquisition is large enough to justify expending resources to conduct due diligence and closing.

Buyer Type by Deal Size

Reason number one for sellers to go to market was retirement. However, note that there is a significant shift when you look at larger businesses to the category of ”Burnt Out”. It may be that those finding themselves in this category never expected to find themselves here and are sick and tired of dealing with the administrative requirements of running a business of this size.

Reason for Seller to Go to Market by Deal Size

The larger the deal the less likely that your buyer is local. You should ensure that you are marketing your business appropriately based on this information. You need to be able to access a wide range of strategic and financial buyers to market your business effectively. And you need to be able to do this while maintaining confidentiality. Not everyone can do this and it assessing your, or your advisor’s, ability to market appropriately may be your most important decision.

Buyer Location by Deal Size

Buying a job was the number one motivation for buyer for deals valued under $1 million. Vertical or horizontal strategic add-on’s were the key motivation in larger transactions.

Number One Motivation for Buyer by Deal Size

Most owners have done little or no exit planning. This can be a key weakness in a business sale in that buyers are left to find weaknesses in due diligence that could have been found with a little planning and areas that could have been strengthened pre-sale are left to the buyer to capture. Larger business do a better job of conducting formal exit planning processes.

Exit Planning

BUSINESS OWNER SURVEY INFORMATION

Of the privately-held businesses that responded to the survey approximately 74% had annual revenues less than $5 million. Nearly 90% of business owners report having the enthusiasm to execute growth strategies, yet just 54% report having the necessary financial resources to successfully execute growth strategies.

Approximately 49% of respondents indicated increasing revenues from current products or services as the area their businesses are most focused on today.

The Most Important Area to Focus On

Most of the respondents are planning to transfer their ownership interest in more than five years from now while only 4% plan to transfer their ownership at the first available opportunity. Note the heavy skew of this graph to the right. This is to be expected with largely entrepreneurial owners. However, it may indicate a mentality that could be damaging to retirement prospects of aging owners if they hold on too long instead of monetizing their investment.

Anticipation of the Ownership Transfer

Approximately 19% of respondents indicated their business cost of equity capital is in the range of 9% – 10%. This represents a significant misunderstanding by many business owners of their cost of equity.

Cost of Equity Capital

Many owners lack awareness of the true cost of operating their business. We’ll discuss the cost of capital and its impact to owners in our next post.

If you would like a copy of the full survey, email me and I will be happy to send you the report.