Psychology has and always will continue to play a major role in the M&A process. The entrepreneur who takes the time to understand a prospective buyer’s fears, both rational and irrational, stands to significantly increase the value of their transaction.
This is one of the biggest challenges to the entrepreneur. Having run the business for years, the entrepreneur becomes immune to many of the risks embedded in the business. Over time, they accept and become comfortable with them. Like the owner of a car that has been owned for years and driven for 50,000 miles: it is dependable, starts every time and there is no fear of the risk that it will break down. To the owner, the time and miles are a comfort factor.
But the viewpoint and perspective to a potential buyer or outside party is completely different. It is an unknown and they will naturally assume and fear the worst. Is it a lemon? What problems are there? Will it leave me stranded? 50,000 is a lot of miles!
Sellers must understand that due to the concept of Loss Aversion, the fear of loss will always be magnified by potential buyers or investors.
Economists Daniel Kahneman & Amos Tversky won a Nobel Peace prize for their groundbreaking work in applying psychological insights in the areas of judgment and decision-making under uncertainty. One of their breakthroughs was around the concept of “Loss Aversion” that concluded the fear of losing money has more influence over the investor than the desire to make money. Because of the pain of loss, people will do more to avoid loss then they will to maximize profit.
This could not be more evident than in a business acquisition. Investors & acquirers understand that there is both risk and opportunity. However, downside risks will be magnified with a greater reduction in value than opportunity or growth will be in upside value. Entrepreneurs must understand this perspective. Any increased risk or uncertainty – either perceived, real, or potential – that is not understood or mitigated can significantly decrease the value of a business.
The optimistic entrepreneur most often wrongly assumes that the upside potential is all that is important to an investor. Don’t get me wrong, investors want and will pay a premium for a business with good upside opportunity, but they will not do so without first understanding and discounting this for the downside risks.
Kahneman & Tversky’s studies conclude that investors are indeed irrational when assessing the potential for loss over gain. In order to avoid losing money, investors will seek odds that are many times greater than the risk of losing. For example, when flipping a coin, most people when given the chance of losing $20 will only take the risk if they have the opportunity to make substantially more than $20 which is the expected return. Despite the 50 / 50 probability, the pain of losing is much greater than the potential reward of making money even when given better odds.
As the overall potential of loss to the investor increases, so does this irrationalness when compared to normal expectations and probability. Often the downside risk of losing can completely offset the opportunity for gain no matter how great the potential return. The investor will either pass on the investment or in the case of a business acquisition offer a much lower valuation.
In order to overcome the challenges of Loss Aversion, entrepreneurs must have answers and be able to show a plan to mitigate the risk and variables that buyers and investors fear.
- What will you do once you sell the business?
- Why are you selling the business? Will you stay involved with the business in some way?
- What do your employees think of the sale?
- Why is there an increase in inventory?
Are actually fears and risks that mean:
- Why are you dumping the business?
- How far are you going to run? Don’t you have any confidence in the future of the business?
- Are employees going to jump ship after the sale?
- Are you losing customers and sales?
While all risks in a business cannot be mitigated, they must be clearly understood by the outside party evaluating the business. You can’t put lipstick on the pig. All risks will come out eventually – especially after a thorough and exhaustive due diligence process. Even if they do not get uncovered, there is the potential of a lawsuit if not disclosed and discovered later.
Outside investors simply want to understand downside risk before they get excited and look at upside potential. Value is maximized by first decreasing downside risk and then by increasing the predictability and clarity of the future. It is only once this downside fear of loss is mitigated, that the potential upside will be fully considered.
About Exit Advisors
Exit Advisors is a Houston, TX based firm that specializes in Mergers & Acquisition (M&A) Advisory and Exit Strategy for privately held companies with transaction sizes ranging from $10-$50 million. Founded by entrepreneurs who have built, operated, and grown successful businesses, Exit Advisors’ partners are not only experienced in handling major transactions for clients but have also engaged in acquisitions and exits of their own. Exit Advisors understands M&A transactions from both the business owner’s and buyer’s perspective and can share that knowledge with their clients.