This is one of the most common questions I get from first-time business buyers in the Acquisition Lab. New buyers unfamiliar with the acquisitions landscape struggle to evaluate the quality of a business and determine if the price matches the quality.
To address this, I created the Quality-Price Matrix. Today, we’ll explore how to define quality, how to understand if a price is fair, and how businesses in the four quadrants should be understood – this matrix will help you make the right decisions on which businesses to pursue and how to approach them during and after the acquisition process.
Why the Quality-Price Matrix Is Necessary
When you navigate private capital markets, you’ll encounter valuations and multiples that seem subjective, without much context for why pricing is set the way it is. Unlike real estate, this is usually because each business is unique, with a number of factors that drive its value. You can’t simply compare it to similar businesses in the industry.
Finding a business to acquire is similar to dating – you’re evaluating where you want to invest your time and money. As a buyer, you’re asking yourself what you think about the business and where would you place it in terms of willingness to spend money and time on it. The Quality-Price Matrix can help to simplify your evaluation.
Before we discuss the four quadrants, let’s define what price is.
What Goes Into the Price of a Business?
Although it might seem redundant to define what purchase price is, we need to define not just the number itself but what that number signifies.
Price can be complicated because it can involve various terms, such as seller notes, personal guarantees, and working capital. The price can also vary depending on if it’s based on adjusted EBITDA, SDE, or another earnings number. For simplicity, we’re assuming in the Quality-Price Matrix that we’re dealing with cash at close. And specifically, when we refer to a price being high or low, we’re referring to the multiple of the business, based on the typical range multiples fall in.
When describing the price as falling “low” or “high,” here’s what we’re really asking: is the multiple higher or lower than the average?
Now, that might have you wondering, if the multiple can vary so much, who sets the price of the business?
The purchase price of a business is set by whoever is selling it – the seller, him or herself, or the broker. The broker will conduct a valuation on the business based on the financials, market conditions, and other tangible and intangible aspects of the business. Here are just a few factors that go into the valuation process:
- Historical growth of the business
- Industry growth and buyer demand for said industry
- Transferability to new ownership
- Brand recognition
- Growth opportunities for the future
- Age of the business
The Four Quadrants of the Quality-Price Matrix (Plus a Bonus)
The matrix has four quadrants across two spectrums: price and quality. Here are the four quadrants of the Quality-Price Matrix:
Undesirables: Low Price, Low Quality
Low quality and low priced deals are the “dogs” of the market – they’re undesirable to most buyers. If the business is priced low, likely this is a reflection of its financials – earnings are low and the business has been trending downward over the last few years. The seller may be looking to get rid of the business quickly, whether due to the four D’s (death, disability, divorce, or disagreement – debt can also be another one) or another reason, and is comfortable (or resigned) to selling it for a low price to simply get it sold.
Although you might be inclined to stay away from low price, low quality businesses, they can present secret opportunities: turnaround businesses. If one of these businesses has an opportunity for growth that you are uniquely suited to address, this could be a deal with great potential where you can quickly increase its value upon acquiring it.
Proud Sellers: High Price, Low Quality
These deals are priced high but are considered lower quality. Similar to what would drive a low price in the previous quadrant, the financial picture likely makes this business a low quality business.
However, if it’s priced high, it’s not because the broker insists on it – a broker ultimately cares about getting a business sold. More likely than not, this is a proud seller who needs a certain amount of money in order to retire properly, and he or she doesn’t really care if the business sells or not. A seller needs to hit a certain number in order for it to make sense, and the seller hasn’t gotten the right offer yet. This seller is exceptionally patient and isn’t in a bind (read: the seller isn’t facing the four D’s).
The opportunity here is similar to the previous quadrant. This could be a business with a lot of low hanging fruit you can quickly address from day one, since it’s a lower quality business with a lot of potential. That said, you’ll be paying a premium for a low quality business, and if you choose to do so, it should be because you see inherent value in the business based on what you can do with it.
If you can see immediate and rapid growth in the near-term soon after closing, this may be a great opportunity for you. Just make sure if you’re using financing, that you can afford the monthly loan installments.
Where Institutional Capital Invests: High Price, High Quality
High priced, high quality deals are the “luxury” deals of the market. People argue this is where brokers often operate, but that’s not true (I’ll show you where they live later on). High prices here are less due to brokers over-inflating prices and rather due to a multiple offer situation or institutional capital interest. These funds have to deploy their investors’ capital and can afford to pay more while still maintaining a good internal rate of return.
Source: Wall Street Mojo
The opportunities with a high priced, high quality business is to either maintain it, as it already performs well, or grow it. If you utilize financing to acquire the business, your focus will be paying off the debt if you simply choose to maintain the business as is. There won’t be much financial cushion, unless you have a plan for improving the value of the business in the near-term.
Undiscovered Talent: Low Price, High Quality
High quality business at low prices – this is what everyone is looking for, isn’t it?
You’ll likely find these deals off-market and not listed by a broker. If you find an off-market deal that falls into this quadrant, it could be because a seller doesn’t see the value of his or her business and is willing to take a lower price, simply because they don’t know better or are looking to offload the business quickly (side note: this is one of many reasons why it’s helpful to have a broker represent your listing when selling your business – they can help you price your business competitively and create enough buyer demand where you can sell your high quality business quickly).
Because these deals are priced low compared to the quality of the business, even by maintaining this business as is, you’ll have an incredible deal. Enough cash flow to take home or reinvest back into the business to grow it. This is a great position to be in.
Where Brokers Live: Fair Market Value
Now, the middle of this matrix is where fair market value lies – where quality and price are both balanced.
For what it’s worth, this is where most brokers operate. Brokers won’t list a business they can’t sell, so it doesn’t behoove them to list an overpriced business. Although brokers want to take on higher quality businesses, they will still value them within a price range where they know they can garner buyer interest. Generally, even if the valuation seems high, it will still be within the fair market value range. The only exception to this is if there are institutional investors involved or if the seller insists on a certain price point.
What Defines a Quality Business
Now, what defines quality?
Quality is a bit more subjective than price; however, there are a few ways to look at quality that will help you wrap your head around quality and how to quantify it. There are four types of quality: intrinsic quality, market quality, subjective quality, and growth versus stability. Let’s break these down.
Intrinsic Quality
Look for businesses where a clear intrinsic value is missing. Although that sounds strange, this becomes an opportunity for you to infuse the business with its intrinsic quality, enhancing its value and increasing the business’s worth. If you’re looking for a framework to identify whether or not a business has intrinsic quality, we teach seven elements to evaluate this aspect in the Acquisition Lab.
Market Quality
Market quality refers to the list price, which is determined by the valuation. Valuation, as alluded to above, takes into consideration the demand in specific industries, among other factors. For example, businesses in the pet industry may sell at higher multiples due to consumer interest. Another example is B2B tech support companies – private equity firms dominate these deals, which ends up driving up the multiple compared to companies in other industries.
That said, you can take a business with low market quality, and if you have the unique skills to improve the issues that drive down its quality, that can be a great opportunity for you.
For example, if you have a company with 90% customer concentration, that’s going to lower the market quality and pose a risk most buyers wouldn’t want to take on. However, if you can get in there and you have the specialized knowledge to figure out that the customer isn’t a risk or figure out how to quickly diversify customer concentration, suddenly the deal will be of a higher quality to you, personally.
Subjective Quality
I’ve already been hinting at the idea of subjective quality, which is the idea that the quality of the business largely depends on you. Valuation is in the eye of the beholder, at the end of the day.
This varies based on individual buyer preferences. Often, finding a fair market value business with high subjective quality can be more effective than searching for off-market deals.
I brokered a deal about a year ago that was a mushroom supplement business where we got 13 offers, and because we were in a multiple offer situation, it ended up selling at a higher price than asking. However, in the eyes of the buyer, he considered the price he paid to be low because of what he could do with it and because of the high demand in that space.
Growth vs. Stability
The market tends to reward businesses experiencing growth, versus businesses that are stable – growth drives higher valuations. The thought process is that a business that’s growing is primed for future success and can offset the risk the buyer will incur in the transferring of the business.
The market tends to view growth as the fundamental driver of value, although this isn’t necessarily true. Growth forces the market to pay a higher valuation for the company because you can get that money back in a short period of time. However, other buyers will look at a high-priced business and ask themselves if that growth is realistically going to continue.
Side note: If you want to figure out how to get your investment back as quickly as possible, I did a video on the risk-opportunity heuristic I’ve used for over 18 years in acquiring, operating, and selling companies, where I walk you through how to do that.
Now, on the other hand, there are buyers who aren’t looking for a growth business. They’re looking for a stable business with no growth that’s boring. Because boring is stable. These buyers are simply looking to pay down the debt and build up the equity without much additional effort. I call this my “buy and chill” crew, and there’s nothing wrong with that.
This approach is comparable to “value investing” versus “growth investing” when investing in the stock market:
Source: The Motley Fool
Whether you choose a growth business or a stable business, this largely comes down to your preference. Some buyers prefer stable, low-growth businesses for steady returns, while others seek high-growth opportunities for faster gains.
The point is, you determine what value a growth business has versus a stable business, based on how you want to operate the business post-close. Although stable businesses are likely capped out on the amount of growth you can introduce into the business and are priced lower, you may be willing to pay a little bit more for a stable business because it suits exactly what you’re looking for.
How to Use the Quality-Price Matrix
By understanding these aspects and using the Quality-Price Matrix, you can better navigate the business buying process and make informed decisions tailored to your goals. When evaluating businesses, gauge where their quality and price fall on this matrix, so you can decide if this is the type of opportunity you’re looking for.
The trick to finding a low priced and high quality business is to find a business that’s priced at fair market value but is of subjectively high quality.
A lot of people are going to tell you to find off-market deals because that’s where the best deals happen, but the downside is you may spend an exorbitant amount of time and energy finding (and waiting) for these deals. It’s not a bad approach, particularly if you’re doing a full-time search or already have an existing network that’s plugged in to off-market deals. However, if you’re looking to buy in the next six months, I encourage you to look at brokerages.
So what’s the best way to buy a high-quality business for a low price?
Find a deal that’s even on quality and price but:
- Has a specific quality or growth opportunity no one else sees, or
- Bring something to the table that makes the deal a promising one for you.
Take this approach to make a regular deal a good opportunity for you.
Ready to acquire a business in the next 12 months? The Acquisition Lab is your first stop. Reach out to us today and get on the fast track to becoming an acquisition entrepreneur.
