(AICPA, By Kenneth Marks; Published August 2014)
For many Baby Boomers who are considering selling their companies in the coming years, a disappointing reality awaits: Their business is not  worth what they thought. Even in today’s hot merger and acquisition market, a  significant valuation gap exists between what many owners believe their  business is worth and what potential buyers are likely to pay.
This  gap has widened in recent years for a number of reasons.

• First, low interest rates and moderate expected returns from  stocks and bonds have led owners to need greater proceeds from a sale, driving  their value ambitions higher.

• Second, at a time when smart companies are investing in  growth and renewal, many owners have tightened their operational belts and  extracted cash. While this business strategy has short-term benefits, owners who  restrict their growth and pay themselves at the expense of losing competitive  ground can diminish the future value and opportunity of the enterprise.

• Third, some businesses fail to generate economic returns in  excess of their true cost of capital. While this concept can seem academic, it  is the basic concept of value creation. While gaps have always existed between  what sellers want and what buyers are willing to pay, the current gap for  middle-market companies is wider than ever. Let’s focus on how to bridge it.

Back to basics
No  matter how strategic the buyer, all valuations eventually boil down to expected  future cash flow. The value of that cash flow is determined by its absolute  level, the risk of achieving the projected amount, and its growth rate coupled  with the future investment required to sustain it. In the traditional sales  process, buyers start by analyzing historical EBITDA as a proxy for cash  flow.
Bridging the gap
To  bridge the valuation gap, a company must shift the conversation from historical  financials to strategic value. It must demonstrate that it is acting on a  credible, forward-looking growth plan that can be leveraged by the buyer. A  company that can articulate and defend its potential, forecast its performance  into the future, and support that forecast with facts, trends, and action steps  can create a strong position from which to lead negotiations.
To establish a sound, strategic  approach for a sale, consider these two principles:

• Know  thyself. Analyzing  and executing a successful exit strategy requires a hard look in the mirror. A company  must examine its business model and its relevance to the future. A deep understanding of a company’s value to the  market—including both customers and investors—allows the business owner to put  into place value-creating strategies that offer potential buyers a vision and a  plan for their investment. Remember, a buyer is an investor. Being able to  articulate and defend a growth strategy to a buyer means you must do your  homework and create well defined initiatives that serve as a road map for  continued growth in cash flow and relevance in the marketplace. Demonstrate  your company’s ability to forecast and manage its growth with empirical data  from existing customers and projects. Buyers often interpret predictability as less  risk and, therefore, higher value. The more accurately you can forecast your  business in revenues, margins, and EBITDA and the more clearly you can understand  and control the earnings drivers, the more successfully you can position your  business for a sale on your terms.

• Know  thy place. Business owners who want to get more for their company  spend time developing solutions that add value to the market segment in which  they operate. They establish a deep sense of the market space and understand who  their competitors are, how their business models work, where they make money,  and where they don’t. They scrutinize data from market research and understand  the competitive landscape and trends. A clear read on how your business fits into the marketplace and how  your growth and strategy will transpire can also widen the pool of  possible “right” buyers. As opposed to a shotgun approach in a broad auction, studying  the defined industry segments that surround your business helps to identify outlying  candidates who may, in the end, see the most value.
  In one example, a niche grading and landscaping firm  took time to understand how each of its competitors engaged with the market and  to explore companies in tangential market segments. By doing so, it found a  strategic buyer that wanted to enter its market segment; a direct competitor  would not have perceived near the value or paid as much. In today’s  environment, a company is wise to optimize its strategic position by exploring partnerships  and alliances that validate its significance to the market, increase its growth  prospects, block competitors, or secure access to certain customers, supply, or  geographies.

Historical  financials validate a business’s ability to be profitable and management’s  ability to operate. By making a strong case for the company’s strategic value,  you give a potential buyer the basis to formulate and pay additional consideration.  By shifting the perspective and discussion from historical numbers to future cash  flow and growth opportunities, you create a productive way to structure a  transaction and monetize the intrinsic value of your business. More important,  you build potential value that a buyer can leverage to realize gains beyond the  near-term numbers.