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Posted: July 13, 2011

Risky business?

How the market's mood can help business owners

Chris Younger

A buyer's perception of risk in a business is inversely correlated to the price he will pay for it. In other words, the more risky a business appears to a buyer, the less he will pay for it. Conversely, the less risky a business appears to a buyer, the more he is likely to pay for it.

The corollary, however, may not necessarily be true for business owners - a business owner, particularly during the early stages of their business's development, may see more opportunity than risk, and as a result may value their business more highly than the market would value it.

We often see this gap in valuation in early stage companies seeking funding - where a founder might see limitless opportunity, an investor might see unlimited risk. As a result, it is important for a business owner seeking financing or a buyer to understand the market's perception of his business, and how that perception can change with certain buyers and in different market conditions.

In public company investing, the Efficient Market Hypothesis suggests that the value of any publicly traded security is its "fair" value, based on the notion that there are thousands of investors, each of whom has access to all relevant information, and these investors will drive the price of a security to its "fair" value.

I won't go into the Efficient Market Hypothesis in detail, but based on what we have seen in our public markets, my sense is that even in public markets where there are lots of investors and terabytes of information, there are certainly periods of time when a security's price deviates from "fair" value. Most of us will recall the late 90's when internet, telecom and media company valuations were off the charts.

In December of 1999, Yahoo traded as high as $108/share, yet just 20 months later Yahoo traded for under $6/share. It is hard to fathom that Yahoo's business model, prospects, or condition changed this radically in such a short period of time. Indeed, the lofty valuations in 1999 were driven by a market that really had no appreciation for risk, and the depressed valuations in 2000 were indicative of a market that had an undue aversion to risk.

Private markets are undoubtedly driven by public market valuations - in other words, during times in which investors are overly enthusiastic about a particular sector and may overlook or ignore risks inherent in that sector, private companies will in turn enjoy higher valuations. The reciprocal is also true.

However, this dynamic is more nuanced in private markets than it is in public markets because private market data is less readily available, and "herd" enthusiasm is less likely to spread in the private markets to drive valuations higher. More importantly, most private deals entail longer periods of due diligence, during which a buyer or investor is likely to gain a better appreciation for the level of risk in a business (and therefore adjust valuation accordingly).

What does all this mean for a private business owner looking for financing or a buyer? It means that in order to get the best possible deal, a business owner must find those buyers or investors who, for their own reasons, might have a more limited view of the risk in their business. This more limited view of risk might be driven by the belief that the buyer believes they can do something different with the business under new ownership, a belief that they can better manage the risk in the business, competition with other bidders (where the business might be seen as "scarce"), or general market exuberance for this particular sector.

In other words, it takes some effort and discipline to find the right buyer, which can only happen when the business owner is able to understand the market as a whole, and is able to uncover those segments of the market where the perception of risk is lower, even if only temporarily.

This also means that the right buyer or investor in one month might not be the right buyer or investor in the next month, as perceptions of risk change over time based on events in and outside of the industry. Likewise, the ideal buyer or investor is not likely to be in any investment banker's rolodex or set of contacts - although this would be the easy way to get a deal done, it is almost certainly not the way to get the best deal done.
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Chris Younger is Managing Director of CapitalValue Advisors, LLC (www.capitalvalue.net). Chris has over 20 years of experience in structuring deals and managing businesses. He was the co-founder and president of a 4,200-employee telecommunications company, has purchased and sold over 35 businesses as a principal and investor, and has been an advisor to hundreds of companies. Additionally, he is the co-author with David Tolson of the book Harvest: The Definitive Guide To Selling Your Company, available on Amazon. He can be contacted at chris@capitalvalue.net.

 

 

Chris Younger is the co-author of Harvest: The Definitive Guide to Selling Your Company and Managing Director of CapitalValue Advisors He can be reached at chris@capitalvalue.net. Visit www.harvestthebook.com for further information.

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