I have a small business that has significant potential. The business has a substantial amount of intellectual property, such as patents and trade secrets, and other forms of growth potential. Do buyers pay for this type of potential, or do they base their valuation strictly on the cash flow my business generates?
Let’s explain what buyers want, and why.
We’ll start by establishing some truths:
- Truth #1: The closer the potential is to being realized, validated, and revenue-generating, the more the buyer will pay for potential.
- Truth #2: Buyers prefer a proven business with revenue and cash flow in which potential has actually been realized over “unrealized” potential.
- Truth #3: Nearly 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.
- Truth #4: Ideas in rough form are worth little to buyers.
Here are a few 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 have never sold one of their products to this customer group.
- Creating a New Product or Service. Acme Corporation believes it could dramatically increase revenues by introducing a new product to the marketplace. The product is just an idea and hasn’t started development yet, has not been user tested and validated, and hasn’t generated any revenue.
- Creating a New Product Idea. Ralph has an amazing business idea for a new product that will cure cancer. He has a business plan, but no progress has been made beyond creating the idea. The idea has not been validated, and no sales have been made.
- Creating a New Business Idea. Roger started a business that looks great on the surface. He has spent over a million dollars building the business, but it generates no revenue and is currently breaking even. Roger believes his 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 will 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? Read on to learn if buyers are willing to pay for potential, and if so, under what circumstances.
Table of Contents
- Characteristics of Potential
- What do Buyers Want?
- Don’t Venture Capitalists Buy Ideas?
- Action Steps
Characteristics of Potential
Here are some general characteristics of potential:
- The idea is only a rough idea. There are no plans or data to back it up, and little has been executed. Implementation has not begun, and the idea has not been validated.
- The business, division, product, service, or idea has not yet generated revenue.
If there is 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 will be willing to pay little for it.
What do Buyers Want?
And what are they willing to pay for?
- Future revenue that is secured by a contract. However, you will 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 product in development that has generated revenue. The stronger the validation, the more the buyer will pay. It’s even better if you have a track record of developing successful products.
- Synergies. However, 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 are competing with other companies to acquire your business.
Don’t Venture Capitalists Buy Ideas?
Yes, but with a catch.
An idea is not all they are buying. They are also buying into a team that will execute the idea and turn it into reality. Venture capitalists do not 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 are investing long-term in a business and a team that will stay in place to execute the idea. 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 will get paid little for selling an idea that someone else will execute.
“To me, ideas are worth nothing unless executed.” – Steve Jobs
With that being said, here is our advice:
- If you have unrealized potential, point it out to a buyer. However, 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 them to motivate the buyer to purchase your business but don’t expect to get paid for ideas if no revenue has been generated.
- To better demonstrate the potential, crystallize it into a one- to two-page business plan. Outline your assumptions and back them up with 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 will be able to conduct a private auction in which multiple buyers are competing for your company.
Keep in mind that while you see the potential in your business, this won’t be a solid basis for selling 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.
“There’s no shortage of great ideas. There’s a shortage of execution.” – Seth Godin