Last fall, during an initial meeting, a tradesman painted a vivid picture of his business model. A very strong order book, large, creditworthy customers with long-standing relationships, three independent service lines, nearly fifty motivated employees, four million euros in annual revenue, and the asking price was stated as 0.5 times revenue. When asked about the expected results for the current year, he replied: “That’s hard to say. The trade is my passion; the business side, not so much.” A look at the most recent financial statements, however, proved sobering: an EBIT margin of ~1%. Unfortunately, this example is not an isolated case.
How does an investor view a target company?
By acquiring a company, an investor is willing to take a risk. They must use future profits to service the debt (interest and principal payments) and expect a return on their invested capital that is commensurate with the risk. However, these future profits are by no means certain. The more likely the investor believes it is that these profits can actually be achieved,
• the lower their expectations for the amount of expected profits will be, or
• the higher the acceptable purchase price will be. Risk, profit, and purchase price are therefore directly related!
What are risks? How can they be mitigated?
Murphy’s Law states: “Anything that can go wrong will go wrong.” Fortunately, not every misfortune is equally likely, nor are its consequences. Taken together, these two factors describe a risk—even in business models. An entrepreneur tries to plan ahead and may therefore decide to offer multiple products and/or not to rely solely on a few large customers. If one product underperforms or a customer drops out, it’s easier to cope with. But how well and stably does this business model function?
The annual financial statements and the business analysis report (BWA) provide only limited insight into this. Both present a company as a whole, without taking individual characteristics into account. This undermines their informative value. For many small and medium-sized business owners, however, this is still sufficient to ensure success. Their many years of experience and daily interactions with customers, suppliers, and employees provide them with enough insight to make sound decisions “based on gut instinct.” A prospective buyer is at a disadvantage here. They may know the market, but not the company or the performance of its individual divisions. They lack this transparency, which increases the risk of an investment. This is precisely where the seller can step in as part of forward-looking preparation for business succession.
How high will future profits be? And how certain are they?
Future profits can only be estimated or systematically derived and planned. They reflect the planner’s or estimator’s expectations regarding the development of revenue, margins, and costs. For the prospective buyer, however, these expectations carry higher risks, as they have less information at their disposal. It is therefore advantageous to establish a common, fact-based foundation for discussion that goes beyond the annual financial statements and the business analysis report (BWA). We are referring to key performance indicators (KPIs). These help measure and highlight the success or failure of a company and its divisions. As part of the due diligence process, a prospective buyer will seek out and ask for this type of information. There are three reasons for this:
1. Past performance metrics help validate their planning, estimates, and underlying assumptions.
2. They provide starting points for optimization measures. To revisit the real-world example mentioned at the beginning: The company’s profitability was below average. But which of the three offerings (products) contribute to success—and how—and what are the levers for strengthening profitability after an acquisition?
3. For strategists and financial investors, another point of interest is how to assess the potential for synergies in market development and/or on the cost side.
The insights gained in this way enable a prospective buyer to develop strategies for the post-acquisition phase and estimate future profits more reliably. This reduces their investment risk.
If this information is not available, it often has to be painstakingly compiled now—in parallel with day-to-day operations. This leads to delays that can jeopardize the sale process. If errors then creep in under time pressure, doubts about the transaction’s legitimacy may arise, and liability risks can emerge.
So how is the purchase price determined?
EUROCONSIL recommends conducting a business valuation before the actual sale process begins. The basis of any proper business valuation is a projection of future profits, with key performance indicators from previous years helping to ensure plausibility (Note: We will not address the applications of net asset valuation here). Ideally, a business valuation is conducted using various methods, resulting in a “valuation range” from which the seller derives the asking price. The prospective buyer will also submit an offer based on the outlook for future profits, their risk assessment, and their individual risk tolerance.
During the purchase price negotiations, the seller can use key performance indicators to clearly demonstrate the company’s potential and thereby substantiate their asking price. The purchase price is then the satisfactory outcome of the negotiations, the terms, and a professionally managed process for both the seller and the buyer.
Anything else?
Yes! Let’s return to the starting point of the low-profit company. When key performance indicators reveal the potential of a company up for sale to a prospective buyer, this naturally applies to the seller as well. They help the seller make rational, faster, and better decisions. If introduced in a timely manner, this will also be reflected in the bottom line. At the time of the sale, this then justifies a higher purchase price, which is also easier to secure due to the greater transparency for the prospective buyer. So it pays off twice over. And finally, key performance indicators also give a prospective buyer an impression of the seller’s management style—keeping the company “in tip-top shape” is simply part of that.
