Imagine this scenario. You receive a call on your cell phone from someone who says he works for one of the big consolidators. He has heard a lot of good things about your shop and he wants to talk. His company is very interested in expanding in your area, and his company only partners with the best shop owners around. He used to be a shop owner and he knows how the industry is changing and knows what a good partner his current employer has been to him. He knows you would be a great fit for his organization. “Let’s get together, maybe for coffee or lunch,” he says. “Or perhaps I can stop by for a quick shop tour.”
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You are naturally curious, and a bit flattered that this big organization thinks highly of you and is talking about you on a first name basis (even if you don’t tell him that). It is a nice change to hear someone say you are doing a good job after what seems like years of being told you are not quick enough, cheap enough or good enough by your customer base.
You want to know more but don’t want to give away too much. You tell him everything has a price but you won’t go cheap. He assures you his company pays up for companies like yours, and in your area you can expect to get at least 4x (5x, 10x, pick your multiple). They normally don’t pay that high, but you have such a good reputation and business, and they are serious about expanding, they are willing to make an exception. Besides, now is a great time to sell because we’re paying more to good shops than we ever have.
Anchor Bias
What just happened? Your contact is engaging in psychological gamesmanship known as anchoring. The anchor bias in business transactions is the common human tendency to rely too heavily on the first piece of information offered. Once an anchor is set subsequent judgments are formed by moving away from that anchor. For example, consider a used car, where the initial price offered sets the starting point for negotiations. Even if a higher multiple is negotiated, it still may be lower than the true economic value of your business.
The Power of the Anchor
Studies show that even when we are clearly aware of the anchor bias in business transactions it still has an overwhelming impact on negotiations. One of my favorite studies uses the last two digits of a person’s social security number. Participants were asked to write down these numbers, then were presented with arbitrary objects they did not know the value of (i.e. a bottle of wine, a piece of computer equipment, etc.). They were then asked to bid for these items. Those with higher two digit numbers consistently bid between 60% and 120% more than those with lower two digit numbers.
Another study involves the pricing of real estate. Two groups were asked to predict the selling price of a beachfront house. One group was given a listing with a general number (i.e. listed for $900,000). Another group was given a listing with a specific price (i.e. listed for $901,389). Those that received the general nonspecific price adjusted their estimates significantly more than those that were given a specific price.
Combating Anchor Bias in Business Transactions
Because the anchor bias in business transactions works even when you are clearly aware of it you want to avoid the anchor at all costs. First, avoid the unsolicited offer and subsequent one-on-one negotiation. A proactive sales process has been determined time and time again to maximize your outcomes. Even if you feel you negotiated the absolute best deal possible it is likely that in the absence of an experienced business transaction deal team there is significant money and terms that you left on the table. Clearly there is a significant incentive for large companies in consolidating industries to negotiate one-on-one, otherwise they would not be so aggressive in reaching out to privately held firms in the industry. The studies above confirm the benefit. In short, the best way to maximize your outcome in a business transaction is to first make the decision you truly want to sell, then, proactively contact potential buyers in a managed process rather than hopefully waiting for a buyer to approach you.
Second, determine the specific price of your business, rather than relying upon a general multiple. Have a trusted professional determine the value of your firm. You will discover that your business may actually be worth different amounts to different buyers. Without getting deep into valuation specifics, businesses have different cost structures, different deal preferences, different financing structures and different strategic and investment requirements. These differences in cost structure, strategy, and capital structure impact the price they are willing to pay for your business. Additionally, the different cost structures and risk factors associated with your business may be interpreted differently by individual acquiring firms. And those are just differences between strategic acquirers in your industry. Financial acquirers have an entire different set of considerations.
Lastly, consider a formal sale process managed by professionals experienced in business transactions instead of engaging in a one-on-one negotiated transaction. There is an old saying in finance: if you have one buyer you have no buyer. A formal sale process is a structured set of activities designed to maximize the price and terms of your business in a quick and efficient transaction. Prior to going to market an advisor will go through a number of steps, including:
- Reverse Due Diligence – a formal review designed to assess a company’s readiness for sale, likeliness of a successful close, as well as to identify and rectify any potential issues prior to going to market.
- Writing a Teaser – A “teaser” document presented on a “no-name” basis to maintain confidentiality. A teaser is designed to create interest from buyers by highlighting certain financial and strategic aspects of your business.
- Creating a CIM – A confidential information memorandum, also referred to as a “book” or CIM, is prepared. The CIM provides a detailed financial and operational description of your business, as well as financial projections, proposed deal structures and expectations regarding expressions of interest and formal offers.
Only once these items are prepared will the business then be ready to engage in the formal auction process, whereby multiple parties are contacted and invited to present offers. Because much of this work is done behind the scenes those who have not gone through this process previously often are surprised by the amount of pre-work that goes into successfully closing a business transaction. But this formal process has been proven as the most effective way to avoid the anchor trap and maximize both price and terms in a transaction.
If you are interested in how to avoid the anchor bias in business transactions or would like to discuss valuation and business negotiations in more depth, please feel free to reach out to me via my contact page. Subscribers you have direct access to my inbox so feel free to email me directly. If you are not yet a subscriber simply enter your email address below, on the subscription page, or anywhere else you see a box to enter your email address.
Until next week!