Do business buyers pay a premium for a “quality” business? Let’s say we have two companies, A, Inc. and B Co. that each have $1 million in earnings for the past five years and are in similar industries. What could make A worth more than B? The answer will surprise many business owners.
First, some may argue that if they both make $1 million in earnings (or $100,000 or $5 million) and those earnings are stable, then theoretically they should be valued the same. However, “quality” does matter and quality companies can demand a premium. But what does “quality” mean in terms of an increased purchase price?
Some Attributes That Don’t Define “Quality”
Each year I get two or three business owners that believe they have such a great web presence, including a URL coveted in their industry, that they should get a premium for their company. Let’s say B Co. has the URL “widget.com” for the widget industry. That is nice, but the fact is that B is earning $1 million annually partly because they already have that URL. That cool name is already built into earnings, and thus built into the sales price. The only bonus a buyer gets is that if B Co. ever shuts down you could sell the name “widget.com” to a competitor. In other words, having a great web site doesn’t mean “quality” in terms of purchase price.
In the same way, a great location, most patents, talented workforce, etc. are already built into earnings and purchase price.
I also get owners that are proud of growing and keeping their company debt-free and believe someone should pay more for such a company. These owners should be proud and I’m always impressed when I witness what these owners have accomplished. But the fact is that as a company grows, it will attract professional investors as buyers, and these investor/buyers WILL use some debt to grow the company – that is how you can use other people’s money to leverage your return on investment. These buyers will also be impressed, but they will not care about keeping it debt free and will not pay a premium for it.
Attributes That Define “Quality”
A “quality” company is a company that buyers feels comfortable and at ease with. What kinds of things am I talking about?
Clean financials. There is nothing more comforting to a buyer than knowing that the $1 million in earnings really is $1 million in earnings. If the owner has been cheating heavily on taxes, the buyer’s comfort level goes down. If the financials are messy and fuzzy, the comfort level goes down.
Management. Buyers focus on the continuity of the business, and management plays a key role in that. Is the business dependent on the owner? Is the owner staying? Is there a management team in place if the owner is leaving? If all the pieces are not in place, buyers start to feel uncomfortable.
The Future. A smart buyer takes a look at the $1 million historical earnings over 5 years, but focuses on the future. They take a close look at booked orders, market trends, life stages of the company’s products and services, etc. Anything that can make the buyer feel comfortable that the $1 million in earnings is sustainable will move that company into the quality territory.
All of the above. Although I said a web address or a talented team doesn’t matter, they do when taken together. A quality company has a number of characteristics that when considered alone wouldn’t bump up a price, but together they cause a buyer to say, “There isn’t a lot to worry about with this company – I could imagine owning this”.
Some of you may be asking, “Are you really saying quality comes down to a buyer’s comfort level?”” Yes. Another way to say this is that it all comes down to risk. The purchase price of business still comes down to future earnings, but with a quality company those earnings have less risk associated with them. Wall Street,
Note to business owners: I said quality company, not perfect company, which don’t exist. So if you are disappointed in reading this because you see problems and challenges in your business, don’t despair. There are problems and challenges with every business, even a quality one.