Negotiating the Price of a Small Business: Part 4

Part 4: Understanding price implications of business model design

 

This is Part 4 of a multipart blog series on negotiating the price of a small private company. If you missed the previous posts, click here.

 

Regardless of the control dynamics we discussed in Part 3, there are certain fundamental business model characteristics that buyers tend to like, so they’ll be willing to pay a premium for them, relative to other comparable companies. 

 

In most deals, the target company has a mix of strengths and weaknesses that leaves lots of room for debate. Here are some of most common business model design characteristics that can swing price negotiations:

 

  1. Maturity. An older business is typically more valuable, because the likelihood of it surviving, or continuing to generate profits similar to prior years, is higher than a similarly positioned younger firm. While not always true (especially for younger, higher-growth companies), the rule of thumb is the older, the better.
  2. Size. A bigger business is typically more valuable, because it has more resources to keep growing its profits (or protect its profits during downturns). Related to this, the bigger companies get, the easier it is to trade in and/or out of them – in other words, they are more “liquid” (and less susceptible to the illiquidity discount discussed in Part 3). For these reason, small private companies usually trade at relatively low multiples (e.g., 3-4x EV/EBITDA) because there are so few buyers, whereas larger enterprises (especially the biggest publicly-traded companies) trade at much higher multiples (e.g., >10X EBITDA) because there is such broad demand for their securities.
  3. Customer dynamics. A business that has lots of customers is typically more valuable than one with just a few, because there is a lower risk of any one customer jeopardizing revenue. As well as this, businesses that have recurring revenue models (e.g. cell phone contracts, insurance premiums, software subscriptions etc.), or at least repeat customer relationships (e.g. retail chains, hair salons etc.), are generally seen as more valuable than businesses that have one-time, non-recurring revenue models. This is because the predictability of revenue is so much better, and the lifetime value of any one customer is so much higher.
  4. Supplier dynamics. A business that has many suppliers for critical inputs is typically more valuable than a comparable business that relies heavily on a few strategic (or irreplaceable) suppliers, simply because the risk of supply disruption is that much lower.
  5. Competitors. A business that has no competitors (or very few), coupled with high barriers to entry, is likely to be more valuable, because it operates in a more defensible niche.
  6. Offerings. A business that offers products and/or services that, to its customers, are relatively small (i.e. under-the-radar spend), relatively mission-critical (i.e. non-discretionary spend), and/or relatively integrated with core systems or operations (i.e. high switching cost), is typically seen as more valuable. This is because revenues are less susceptible to economic downturns or customer whims, than those derived from products and/or services that are discretionary “big-ticket” items. 
  7. Operations. A business that uses simple processes is more valuable than a comparable company that generates similar profits with more complexity, because it is easier for an outside buyer to understand and run it effectively. Relatedly, a business that uses non-specialized assets which aren’t linked to any one client’s demand is sometimes seen as more valuable, because assets are easier to maintain or replace, and/or less likely to be made redundant by the loss of any one customer. 

 

It is rare to find a business that has all of these characteristics. But, to the extent that a target company demonstrates them all, a seller is in a good position to push the price up. Conversely, if the target company doesn’t exhibit any of these features, the seller can expect to get grinded down on price.

 

To learn more, keep reading Part 5 in our Negotiating the Sale of a Small Private Company series, where we look at the industry characteristics that can enhance value. A reminder that a complete version of this content is available to EquityMaven’s subscribers in e-book format.