Buyers Buy the Future but Pay for the Past

There is a hand full of truisms in middle-market Merger & Acquisitions (M&A) and this is one of my favorites.  It explains so much about valuation and, even more importantly, sale price in one simple phrase.  Let me explain.

It is easy to understand that buyers purchase a business because they are excited about the future prospects of the business.  If they did not believe your business had a bright future they would “take a pass’ and move on to the next opportunity.  When we market your business, it is all about selling the future prospects of your business.  So, when we are successful in receiving an offer from a buyer, we have been successful in selling the future.  The buyer has bought the future.  This is critical in getting the buyer to say yes. 

How do most buyers evaluate the future?  They look at the past.  Their excitement (and our marketing strategy for your business) must be supported by the past.  Your historical financial performance must support your expectations of the future financial performance of your business.  More importantly, your historical financial performance must support the buyer’s expectations for the future financial performance of your company.  If there is a disconnect between your historical financial performance and your business’ prospects (as represented in a financial forecast), then we will have a difficult time convincing the buyer to “buy the future.”  When the financial forecast is aligned with the past, this ‘buy-in” is much easier.  Simply stated, the past is critical to supporting the future expectations of any buyer.

So, what does this mean for valuation?  As you probably already know, business valuation is simply the discounted present value of the expected future cash flows available to the owner.  The focus on future cash flows underlines the concept that buyer buy the future.  This is what they are buying; the future cash flows.  Indirectly, the negotiation of value (price) becomes centered on what is a reasonable expectation for these future cash flows.  The buyer’s expectation for these future cash flow is what will drive their perception of value.  So, when the expectation of future cash flow is consistent with the past, the price reflects both the past and the future.  But if the expected future cash flows, as represented by the seller, are much rosier than the past, we find that the buyer’s offer is based on the past.  In both cases, they are paying for the past.  In one case the past supports the seller’s representation of the future and the asking price is largely obtainable; and in the other, the past does not support the seller’s representation of the future and it will be difficult to achieve the asking price.

The take away is to make sure that historical earnings support the seller's forecasted cash flow and therefore the seller’s value expectations. 

Alan D. Austin, CFA