by: Jason Frank
The valuation expectations of buyers and sellers of business enterprises are usually misaligned, even in well-performing marketplaces; therefore, valuation due diligence takes on an all-important role in determining whether a transaction will come to fruition. Even in healthy economic times, many factors beyond financial results must be addressed when valuing a target company for a merger or acquisition.
Because all parties are using essentially the same well-known and accepted valuation methodologies, assumptions become the most important component of the equation, which is the reason scrutiny of the underlying details in any deal is crucial. If the assumptions are accurate — and properly analysed and applied — much of the subjectivity is eliminated, and the valuation becomes more “scientific.”
Managing Valuation Expectations
In a typical M&A transaction, the seller looks to receive maximum value for its asset, while the buyer is willing to provide just enough compensation to entice the owner to sell. The ultimate value is typically a compromise between these two points.
Today, there is a material dichotomy between buyer and seller expectations. While there is a large pipeline of potential transaction activity, current economic and political conditions have caused many companies to go to market for the wrong reasons (i.e. liquidity, financial performance, tax code, etc.). Reasons could also be that there are too many deals being marketed with “hair on them,” and too few good quality companies for sale. This trend has created two unique and different markets for M&A transactions:
- The buyer’s market: This market is largely composed of stressed deals. The sheer number of these difficult transactions, as well as the long duration of the marketing processes, lack of qualified buyers, and willingness of the sellers to rid themselves of these assets, has given buyers control of the valuations.
- The seller’s market: Attractive, well performing companies dominate this market. Sellers are in complete control, which means transactions are valued and, ultimately, bid up to pre-recession multiples.
The bifurcation of the M&A market, with all the variables to consider, has made valuation extremely challenging.
Traditional M&A Valuation Methods
Valuation methods are grouped under three general approaches: the market approach, incomeapproach, and cost approach. At various times, one method could appear more appropriate than another, depending on the relative circumstances and availability of information in each case.
The most commonly used valuation methods for M&A transactions are:
- Market Approach: Guideline Publicly Traded Company Method
- Market Approach: Guideline Merged or Acquired Company Method
- Income Approach: Discounted Cash-Flow Method
- Asset Approach
Regardless of the method utilized, it is important to scrutinize the underlying assumptions in an M&A valuation. The quality, relevance, and accuracy of the inputs determines the difference between a “science” and an “art.” A formula and its inputs can be manipulated to provide any result desired. A true valuation not only will follow the guideline methodologies, but will be realistic in its findings.
Valuation of a Target Company in Today’s Market
Determining an accurate valuation of a target company is extremely difficult in today’s market. Not only has the economic and political environment wreaked havoc on a business’s operational, financial and strategic initiatives, but many other factors contribute to the complexity of valuing a target company.
Even in good economic times, many factors must be addressed when valuing a target company beyond just financial results. Following is a partial list of major issues to address when attempting to value a target company accurately.
- Is the target a public versus a private company?
- Is the industry growing, contracting, or plateaued?
- Is the industry global, domestic, or regional?
- How competitive is the industry and its participants?
- How experienced is the management team, and are its members capable of taking the company to the next level?
- Does the target company have strong relationships with its suppliers, vendors and distributors?
- Are there significant regulation or compliance requirements related to business?
- Does the business have intellectual property, and is it properly protected from infringement?
- What is the value of the intellectual property, and is it transferable upon a change of control?
Publicly traded companies are generally easier to value due to the higher quality and quantity of available information for the company. Typically, stock analysts complete independent research and analysis that can be utilized for valuation purposes. Also, a company’s stock price can be used as an independent basis of value.
However, additional factors must be considered. Will the target require a significant premium over its current valuation, or is the market fairly valuing the entity and its future prospects? Will the target welcome an offer from a potential suitor, or will the situation be hostile? Are their cost synergies that can be extracted from the target to extract additional value?
Privately held companies are generally plagued by a lesser quality and quantity of information that can be used in an analysis. Also, a private company’s capital structure could be more complex with various classes of equity and debt securities. Lastly, the final value of a closely-held, private business could differ from the value calculated using the established methods of appraisal due to the consideration of various types of discounts or premiums. For example, control shares are generally more valuable than minority shares because they contain a bundle of rights that minority shares do not enjoy, such as the abilitity to:
- Participate in the appointment or change of operational management and members of the board of directors;
- Determine management compensation and prerequisites;
- Set operational and strategic policies, and change the course of the business;
- Negotiate and consummate mergers and transactions;
- Liquidate, dissolve, sell out, or recapitalize the company;
- Declare and pay cash and/or stock dividends;
- Change articles of incorporation or bylaws; and
- Block any or all of the above actions.
Additionally, several additional factors must be considered:
- What is the corporate structure, and will it create tax complications?
- Is the target company reliant on a few key individuals, and would they be willing to join the acquirer?
- Has the current ownership group incurred extraordinary expenses or received large dividends or other forms of compensation that would not be incurred going forward post transaction?
- Is the proposed transaction an asset sale or a stock sale?
Even if the Valuation is Appropriate, Sometimes it is Irrelevant
If you are an active buyer (strategic or financial) looking for an attractive, well performing company in today’s marketplace, get ready for an extremely competitive process. Transactions are being valued and, ultimately, bid up to extremely high multiples.
Advantageous sellers are partnering with Investment Banking Advisors to facilitate identification, evaluation, selection and execution of the best strategic alternatives. These advisors prepare and formulate value projections, identify counter parties, prepare marketing materials, and assist with the myriad of issues and decisions sellers face. In other words, sellers are extremely prepared when they decide to go to market.
In a properly executed sale process, the Investment Banking Advisor's goal is to create sufficient interest in the selling company, expecting to create a competitive auction. The greater the number of interested parties in a competitive sale process, the higher the ultimate values realized. Sellers and their Investment Banking Advisors are aware of their advantaged position and are relying more than ever on auctions to market their assets. This is resulting in motivated financial and strategic buyers bidding up the transaction price.
Additionally, there are several other factors contributing to the high multiples and, therefore, the control enjoyed by sellers.
- There are too many deals being marketed with “hair on them,” and too few good quality companies for sale.
- Equity sponsors have significant dry powder that needs to be deployed before their investors redeem. Estimates of funds committed but not yet invested range from $900 billion to $1 trillion. This overhang is too large to be absorbed in current market conditions. Private equity funds are incentivized to deploy committed capital, so they are expected to invest significant amounts in numerous transactions in an accelerated timeframe. When a strong transaction comes across their desk, many sponsors are determined to add it into their portfolio. Price becomes a secondary factor in the pursuit. Unfortunately for sponsors, it has become difficult to achieve targeted returns through financial leverage and market lift. Value is achieved by realizing profitable revenue growth and operational efficiencies.
- Financial institutions are being pressured to lend again and deploy capital. Thus, debt facilities are very competitively priced. Strategic buyers have managed their balance sheets effectively over the last several years and are flush with cash. When an attractive, synergistic acquisition opportunity presents itself, they are willing to pay a premium.
It is extremely difficult to arrive at an accurate valuation of a target company in today’s complex marketplace. Since all parties are using essentially the same well-known and accepted valuation methodologies, assumptions become the most important part of the equation. This is why it is very important to scrutinize the underlying details in any deal, and why quality, relevancy and accuracy of the inputs elevates M&A valuation from a “science” to an “art."
Original article from the ABL and can be found here.