04 Feb When are buyers willing to pay a premium for a business?
There’s an adage in the M&A industry that strategic buyers generally pay more for businesses than financial buyers. That belief is supported by a recent Pepperdine University Private Capital Markets Report in which half of the respondents reported that strategic buyers pay up to 20% more for middle market business acquisitions.
When would a buyer pay a premium? Let’s look at what a strategic buyer may be considering with an acquisition:
- Vertical integration
- Horizontal integration
- Eliminate competition
- Reduce some of their own weaknesses (e.g., technology, marketing, distribution, R&D, etc.)
Buyers that pay a premium are looking for the potential to increase value to their shareholders. That means that if they assess your company as an optimal fit, they will be able to pay more.
Let’s define what we mean by “paying a premium”:
- Start with the standalone value of a company (based on DCF analysis & comparable transactions)
- The premium is the amount above the standalone value that a buyer will pay because the combination will be more profitable together than separate. This is called “accretive earnings”.
- The buyer is estimating synergy from the combined companies based on potential cost savings and/or potential revenue growth.
In many cases, whether or not a business will find a buyer who is willing to pay more is based on some fundamental aspects of the company. For example, does the business have recurring revenue? Buyers like predictability and will be pleased that a regular amount of income is received every month. Businesses with huge market shares will also do well. Buyers will find a company to be a safer investment if there are many current and potential customers. Unique assets, such as advanced technology, legally protected intellectual property, and trade secrets will also be well-received by buyers.
In many cases, larger companies buy smaller ones to avoid competition. This is common among technology companies who are trying to avoid more agile newcomers coming on the market and being a threat. In other situations, a buyer will want to acquire a business to merge with their existing assets. For example, a buyer may want to buy into your customer base to be able to cross-sell their IT solutions.
For many sellers, finding a buyer who is willing to pay a premium will be a primary goal. These sellers should seek to strategically build their company according to the guidelines above. That’s what we do with our clients in our value enhancement engagements. Over time, the efforts that you make to reduce your weaknesses and limit competition will likely result in a higher price when it’s time to sell.