Valuing Potential

Do buyers of businesses pay for potential, or do they base their valuation strictly on the cash flow your business generates? Here I’ll explain what buyers want and why.

I’ll start by establishing some truths:

  • The closer potential is to being realized, validated, and revenue-generating, the more the buyer will pay for it.
  • Buyers prefer a proven business with revenue and cash flow where potential has been realized as opposed to “unrealized” potential.
  • Every business has unrealized potential. The closer the potential in your business is to being realized, the higher the likelihood you can be paid for it.
  • Ideas in their rough form are worth little to buyers. As Steve Jobs said, “Ideas are worth nothing unless executed. Execution is worth millions.”

Here are some examples of potential:

  • Selling to a New Customer Group: Acme Corporation believes they could dramatically grow their business by selling their existing products to a new customer group. The idea is just an idea at this point, and they haven’t yet sold any products to this customer group.
  • Creating a New Product or Service: Wayne Enterprises thinks it can substantially increase revenues by introducing a new product to the marketplace. The product hasn’t started development yet, hasn’t been user tested and validated, and hasn’t generated any revenue.
  • Creating a New Product Idea: Ralph has an amazing business idea for a product that will cure cancer. He has a business plan, but no progress has been made beyond creating the idea. The idea hasn’t been validated, and no sales have been made.
  • Creating a New Business Idea: Kate started a business that looks great on the surface. She’s spent over a million dollars building the business, but it generates little revenue and is currently breaking even. Kate believes her business has significant potential, but the business hasn’t generated any profits yet.

These are examples you may see as potential opportunities, but when selling a business, you’ll soon discover that most buyers will be willing to pay little for these types of potential. Under what circumstances are buyers willing to pay for potential? If potential exists in your business, what can you do to get paid for this potential? 

Here are some general characteristics of potential that buyers won’t pay for:

  • The idea is only a rough idea. There are no plans or data to back it up, and little has been executed. Implementation hasn’t begun, and the idea hasn’t been validated.
  • The business, division, product, service, or idea hasn’t yet generated revenue.

If there’s no proof the idea will generate revenue, it may be a good idea, but it’s still just an idea. If no revenue has been generated, most buyers won’t be willing to pay anything for it. Nonetheless, such a plan may be the icing on the cake for the buyer to decide to move forward after their due diligence investigation.

What are buyers willing to pay for?

Buyers want:

  • Future revenue with a high degree of certainty. In fact, you’ll achieve a higher valuation if you wait until the revenue from the contract is recognized on your financials before you attempt to sell your company.
  • A new product that’s been developed and has generated revenue. The stronger the validation, the more buyers will be willing to pay. It’s even better if you have a track record of developing successful products.
  • Synergies – but buyers won’t pay for synergies unless they have to. Generally, only larger companies pay for synergies and only in an auction in which they’re competing with others to acquire your business. 

Don’t venture capitalists buy ideas? Yes, but with a catch. 

An idea isn’t all they’re buying. They’re also investing in a team that will execute that idea and turn it into reality. Venture capitalists don’t buy a business outright. They normally make a minority investment in a business in which the ownership team will remain on to execute the idea. 

So venture capitalists aren’t buying an idea. Rather, they’re investing long-term in a business and a team that will stay in place to follow through on the proposition. In earlier rounds, investors focus more on the strength of the team than the actual idea. If you expect to create a visionary idea and then sell that idea to a third party to execute, think again because you’ll get paid little for selling an idea that someone else will execute.

Here’s my practical advice on ideas and potential:

  • If you have unrealized potential, point it out to a buyer. But the less polished and un-validated the opportunity, the less you can expect to get paid for it.
  • Treat ideas as icing on the cake. Use potential to motivate the buyer to purchase your business, but don’t expect to get paid if the idea hasn’t generated revenue.
  • To better demonstrate the potential, crystallize it into a one-to-two-page business plan. Outline your assumptions and back them up with hard data. Better yet, run a series of experiments to validate your assumptions in the real world.
  • If you believe a buyer may pay for synergies, consult with an M&A advisor. An M&A advisor may be able to determine if synergies exist and conduct a private auction in which multiple buyers compete to acquire your company, thereby driving up the price.

Keep in mind that while you may see potential in your business, buyers won’t see this as a primary reason for purchasing your company. What buyers want is actual revenue and profitability, so the more you can demonstrate the revenue-generating possibilities of your business’s opportunities for growth, the more interested they will be in buying your company.