Price is the paramount issue in a merger and acquisition transaction. Beyond anything else, it determines the amount of value that is transferred to the seller in exchange for ownership of the business that is for sale. It is the number-one concern for both buyers and sellers, and it ultimately determines whether or not a transaction can be consummated. It is also always critical to distinguish between price and terms. The price could be very favorable to a seller but be crippled by alternative terms that make the transaction unpalatable, costly, and risky. There are several established and traditional valuation methods used to estimate the price range within which a business will be sold. The actual price, however, is ultimately determined by what companies are willing to pay, which will be as much a function of market conditions as it is of economic formulas.
Although a formal valuation of the seller’s business is a vital component of the buyer’s analysis of the proposed transaction, it is important to realize that valuation is not an exact science, nor will valuation alone typically drive the terms and pricing of the transaction. There are numerous acceptable valuation methods, and in most situations, each will yield a different result. Unfortunately, no method will answer the question: “How much is the business actually worth?” That question can be answered only through the receipt and negotiation of term sheets. The reality is that the market determines the price, and valuation, while an important exercise, is only indicative of what the market has paid for similar companies in the past. That said, there is clearly utility in the exercise of valuation because both buyers and sellers use these tools to gain insight into whether their perception of value is likely to intersect the other party’s perception of value.
In late 2017, at the time this manuscript went to print, valuations in a variety of industries had reached alarming highs. Was this the “new normal” or were we on the cusp of another market bubble? Many felt that traditional EBITDA-based valuation methodologies had become extinct and failed to recognize other variables and metrics that drive shareholder value, while skeptics felt strongly that financial performance still trumped other intangibles. Should Apple have paid over $3 billion for Beats? Should Microsoft have paid over $25 billion for LinkedIn? Should Facebook have paid $1 billion for Instagram?
Even non-public-, non-M&A- driven valuations seemed frothy. In the spring of 2017, ride-hailing company Lyft Inc. (a clear number two in the market compared to Uber) fetched a recent financing round that valued it at $7.5 billion and included some pretty smart investors, including Alibaba, General Motors, and Andreessen Horowitz, notwithstanding operating losses. Note that market leader Uber had been valued at $70 billion in its most recent round of capital raising.
Where the “right” valuation should be in these times of uncertainty is hotly debated among pundits, experts, investment bankers, and buyers and sellers. Low interest rates give way to elevated profit margin. The Trump administration’s promises of tax cuts and regulatory reform may further drive market valuations if they come to fruition. But beyond the Beltway, new metrics are being recognized and reinforced that will change how companies are valued—in the context of M&A or otherwise—as we enter the age of robotics, AI, big data, brand loyalty, customer experience, autonomous vehicles, drones, and other technological phenomena that will directly and indirectly influence valuation in the decades ahead of us. See Figure 9-1.
Figure 9-1. The Stunning Value of Digital Companies
An incredible $2.8 trillion—this is the market capitalization of five of the six largest companies in the United States, Amazon, Apple, Alphabet/Google, Facebook, and Microsoft. Three of them are younger than twenty-five, two of them barely forty-five years old—and all are located on the U.S. West Coast. To put that into context: The combined market value of the thirty companies listed in Germany’s DAX 30 is a mere $1.1 trillion, and the most valuable company there, SAP with $100 billion value, turned forty-five this year. Almost every other significant player in the German market was founded a hundred or more years ago. As of late 2017, Apple had readied a market capitalization of more than $900 billion, making it the first global company to be just a few steps away from a $1 trillion valuation.
And another digital company is rising fast in valuation. Tesla—yes, Tesla is a digital company, not so much a car company—surpassed GM and Ford recently in market capitalization, and now is approaching the market cap of BMW, the top German car company.
We often talk about EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples as the key price determiner. EBITDA is a metric or formula that essentially values a company based on its historical and likely future cash flow. When the markets are robust, you hear stories of companies in the hottest industries commanding EBITDA multiples of eight, ten, and even twelve times their earnings. In a softer market and in weaker industries, buyers may be lucky to get one and a half or two times their earnings. In other industries, such as technology, biotech, and software, the EBITDA multiple may not be the best formula for determining a company’s true value, and the multiplier may be based on gross sales, number of customers, contracts, or some other key economic variable.
To sell a company at the higher end of the EBITDA multiple range prevailing in the market, you will need to demonstrate to the buyer a series of value drivers that can substantiate and support a higher price. These value drivers vary from company to company, but they can generally include a strong management team (that will commit to staying in place after the closing), a loyal customer base, dedicated and profitable distribution channels, a culture of innovation and creativity with a robust new product or service pipeline, a deep inventory of protectable intellectual property, a global market presence, demand trends that appear strong in the future, and an overall competitive advantage that appears to be sustainable over the medium- to long-term.
Conversely, it is critical to conduct an analysis of any possible value leakage and to fill those holes well before any potential buyers conduct their strategic due diligence. Failure to maximize value and take corrective pre-transactional action on problems that are likely to be identified by a buyer and that will influence price and terms could not only cost you millions of dollars in an EBITDA calculation, but also subject you to legal action for failure to meet your fiduciary obligations toward the minority shareholders of your company. Another mistake that is often made is the failure to harvest or recognize key intangible assets that will be valuable to a buyer after closing. The variables driving a leakage in value can include gaps in the management team, tax and regulatory problems, pending litigation, disgruntled channel and strategic partners, accounting and financial statement issues, hasty due diligence preparation, and a seller’s willingness to accept “tougher than market” deal terms because it is perceived to be desperate or overanxious to sell the company. The prevalence of value leakage is more common than you might think: The idea that sellers would purposely or negligently drop critical strategic balls that would otherwise have fetched them millions more in purchase price seems counterintuitive, but in a fall 2007 KPMG survey of corporate sellers and private equity fund managers, nearly 50 percent said that they failed to maximize value in their latest sale or portfolio divestiture and, even more alarmingly, two-thirds of the respondents said that they were not likely to correct the practices that led to the acknowledged undervaluation over the next five years.
To determine the value of a company, several key questions must be addressed: To whom is the asset valuable? In what context is the asset worth paying for? Before we get into the specifics of how businesses are valued, it is important to understand how prices are set in the real world.
The key question in pricing is: “How do I, the seller, extract as much value from the buyer as possible?” The obvious answer is: “Get as much as the business is worth to the buyer!” Although this would certainly maximize the price paid, there are certain real-world constraints that prevent this from happening. First, people generally do not advertise how much something is worth to them. A man who is dying of thirst will value a glass of water far more than someone who has just drunk a glass of water; however, unless the potential water customers are willing to identify their situation, the water vendor may be able to charge only a single price. Similarly, just as a computer is worthless to someone who does not have electricity, worth a small amount to a three-year-old child, and potentially worth millions to a technology entrepreneur, it is impossible to charge a single price and capture all of the value provided to each of the three potential computer customers.
In the real world, this problem is addressed through versioning, where vendors force customers to identify the segment in which they belong by providing different options that appeal to each segment differently. For the child, a basic kid’s computer is all that is necessary. The technology entrepreneur, on the other hand, will probably prefer a more high-end computer and will pay a substantially different price as a result. Similarly, a Tiffany’s diamond, while often the same quality as diamonds sold at other retail locations, commands a 30 to 50 percent premium because the Tiffany’s brand is attached.
There are several key lessons from the world of pricing:
Each potential buyer will value a business differently.
Getting the buyer to identify itself (or its intentions) helps determine what good should be offered and how that good will be valued.
Cost is often not relevant in determining market value (i.e., the price of bottled water is not at all related to the cost of the water, which is ostensibly free).
A single set price will exclude certain buyers from bidding and will not ensure that the maximum price is paid.
An auction pricing format is generally believed to be the best way for a seller to maximize the price paid by the buyer. There are several different auction formats, each with generally the same principles: (1) A competitive process ensures that the price offered is near the maximum price that any individual buyer is willing to pay, (2) the “winner” pays more than all the other bidders are willing to pay, and (3) the “winner” generally pays just a little bit more than what the second-highest bidder was willing to pay.
When this format is applied to businesses, there are several key differences. First, no business buyer likes to participate in an auction, as these buyers understand the principle and the expected outcome, and second, it is generally very difficult to ensure that each potential bidder adheres to the same process and schedule as the other bidders. Nevertheless, the concept of an auction is a valuable tool for a seller and should be simulated, as much as is reasonably possible, during a sales process.
Finally, an auction, while great for maximizing the price that is actually paid, still does not help inform the buyer or seller of what the likely outcome of the auction process will be. For that, we turn to a more traditional valuation exercise.
The valuation of a business may be done by the seller prior to entertaining prospective buyers, by a buyer who identifies a specific target, by an investment banker or other intermediary involved in the transaction process, or by all parties during negotiations to resolve a dispute over price. The fair market value of a business is generally defined as the amount at which property would change hands between a willing seller and a willing buyer when neither is under compulsion and both have reasonable knowledge of the relevant facts. However, this is often an unrealistic scenario, as buyers and sellers are forced to consider “investment” or “strategic” value beyond a street analysis of fair market value.
In the context of a proposed acquisition, a proper valuation model will evaluate what the seller’s business would look like under the umbrella of the prospective buyer’s company (i.e., create a forward-looking “pro forma” financial model). The first step is to normalize current operating results to establish net free cash flow. Next, it is important to examine “what-if” scenarios to determine how specific line items would change under various circumstances. This exercise identifies a range of strategic values based on the projected earnings stream of the seller’s company under its proposed new ownership. The greater the synergy, the higher this earnings stream and the higher the purchase price.
To arrive at this strategic value, large amounts of financial data and general information on many aspects of the seller’s business are required, such as the quality of management or overlapping functions within both businesses. The valuation exercise will attempt to assess how the value of the target company will be affected by any changes in the operations or foundation of the company as a result of the proposed transaction, such as a loss of key customers or key managers.
A thorough valuation should also examine the seller’s intangible assets when determining strategic value. The list of intangible assets should include items such as customer lists, brands, intellectual property, patents, license and distributorship agreements, regulatory approvals, leasehold interests, and employment contracts. The greater the extent to which the seller can supply specifics on its intangibles, since certain intangibles may not be readily apparent, the more likely it is that they will enhance the valuation.
There are three main approaches to valuation: comparable company and comparable transaction analysis, asset valuation, and discounted cash flow (DCF) valuation. The first approach identifies companies that are comparable to the one in question and looks at their performance ratios (e.g., value as a ratio of revenue) as guidance in valuing the business in question. The second approach is relevant to businesses with high levels of fixed assets and involves valuing the measurable pieces of the business in order to determine the value of the whole. The final approach looks at the amount of cash that the business is likely to produce each year going forward, then discounts those future cash flows to present value (i.e., today) terms.
Of the three main methods of valuation, no single method will provide a price that cannot be questioned. The methods are useful in that they provide points from which to start and supply a range of reasonable values grounded in reasonable assumptions and actual facts. In the end, it is vital to remember that the value or price of a company is largely dependent on the true motivations and goals of the key players involved, as well as on the transaction’s timing.
Comparable Company and Comparable Transaction Analysis. The notion of comparable worth pertains to the use of performance and price data of publicly and privately held companies in order to estimate the value of a similar business. The premise of comparable company analysis is that by examining publicly held companies that operate in the same or a similar industry, one can infer how shareholders would value the target company if it were publicly traded. Since market theory holds that publicly traded companies are valued “fairly” given all available information, then any public business that is similar to the target would be valued using similar metrics. This is not to say that “since our company is a large retailer, we are worth the same as other large retailers,” but rather, that the relative value of a large retailer as a percentage of sales may be a good way to value a private retailer. Similarly, comparable transaction analysis is done by identifying transactions involving privately held companies with operations similar to those of the target. By examining the consummated transaction value in relation to the relevant company metric, a value for the target can be inferred.
The justification for this method lies in the premise that potential buyers will not pay more for the target company than what they would spend for a similar company that trades publicly or that has been sold in a recent transaction. The challenge of this approach is that the comparison is good only to the extent that the companies chosen for the analysis are truly comparable to the target. Obviously, the companies should be as similar to the target as possible, particularly with regard to product offering, size of revenue base, and growth rate.
Once a preliminary range of valuations based on this method has been determined, it is often necessary to adjust the price for situations specific to the target company. If, for example, the target company has profits that are consistently above industry averages because of an unusually low cost structure, then the value of the target firm must be adjusted upward from the comparables in order to account for that competitive advantage. In the example just mentioned, the buyer must be able to see and understand the justification for the target company’s being valued higher than the comparable analysis dictates or she will not be willing to pay the premium.
In some cases, a comparable analysis may not be possible or may yield unrealistic results. If the target company is closely held, comparable company or transaction analysis may be difficult or impossible, as the metrics necessary to make crucial judgments may not be available. In addition, the goals of financial reporting for a publicly held company can be quite different from those for a private company. While a publicly held company’s management strives to show high earnings on its financial reports in order to attract investors, a closely held private company’s management may be a sole entrepreneur or small group that wishes to minimize the earnings shown on its financial reports in order to minimize the tax burden. While both goals are legitimate, the key financial ratios of a target company that is closely held may vary widely from those of similar public companies in the industry.
Asset Valuation Method. If the operation of a target company’s business relies heavily on fixed assets, a prospective buyer may conduct an asset valuation when attempting to determine a price for the business. The justification for an asset valuation in this case is that the buyer should pay no more for the target company than he would pay to obtain or build a comparable set of assets on the open market. Within these guidelines, the buyer can choose how to value these substitute assets using (1) the “cost of reproduction” or (2) the “cost of replacement” method. The cost of reproduction takes into account the cost to construct a substitute asset using the same materials as the original at current prices, while the cost of replacement utilizes the cost to replace the original asset at current prices adhering to current standards. In either case, it is also necessary to consider the time that would be required to assemble the assets and initiate normal operations.
When using the asset valuation method, all assets of the target company, both tangible and intangible, must be considered. Tangible assets, as the name implies, refers to actual physical things like machinery and equipment, real estate, vehicles, office furniture and fixtures, land, and inventory. Markets exist where these assets are actively traded, and therefore their value is fairly easy to determine. Intangible assets include patents, trade secrets, brands, customer lists, supplier relationships, and other similar items that do not trade actively in an established market. These intangibles are often referred to as the company’s goodwill and defined as the difference in value between the company’s hard assets and the true value of the company. While intangibles do have legitimate value, it is often difficult to convince a buyer of the exact value that an intangible asset provides. Generally, it is in the seller’s best interest to supply an acquirer with as much information about the company’s intangibles as possible. The greater the value of goodwill that can be attributed to specific, well-defined intangibles, the higher the price at which the company is likely to be valued. For example, rather than lumping patents that a company holds under “intangible goodwill” or as a single line item, each patent should be listed separately and supporting documentation provided that details crucial facts such as patent scope, dates of expiration, and individual effects on the company’s operations.
Discounted Cash Flow (DCF) Valuation Method. Perhaps the most commonly used method for determining the price of a company is the DCF valuation method. In a DCF valuation, projections of the target company’s future free cash flow are discounted to the present and summed to determine the current value. The implication of a DCF valuation is that when ownership of the target company changes hands, the buyer will own the cash flows created by the continued operations of the target. Key elements of the DCF model are financial projections, the concept of free cash flow, and the cost of capital used to calculate an appropriate discount rate.
The first step in a DCF valuation is developing projections of the target company’s financial statements. Intimate knowledge of the target company’s operations and its historical financial results and numerous assumptions as to the implied future growth rate of the company and its industry are key elements of grounded financial projections. In addition, it is necessary to determine a reasonable forecast horizon, which, depending on the industry and the company stage, can range between five and ten years.
The next step in a DCF valuation is determining the target company’s future free cash flows. The most basic definition of free cash flows is cash that is left over after all expenses (including cost of goods sold, operating and overhead expenses, interest and tax expenses, and capital expenditures) have been accounted for; it is capital generated by the business that is not needed for continued operations, and, accordingly, it is the capital available to return to shareholders without impairing the future performance of the business. Determining the free cash flows of a business is a function of understanding and utilizing the basic financial data provided in the target’s projected financial statements. That being said, in determining a company’s free cash flows, it is extremely important to have both general knowledge of financial statements and a thorough understanding of the target company’s accounting practices, as projections are often heavily influenced by historical financial statement data.
After determining the free cash flows for the target over the designated forecast period (typically five years), a terminal value is assigned to all future cash flows (everything after five years), which should be consistent with both industry growth rates and inflation predications. (Note: During the Internet bubble, optimistic entrepreneurs often made the mistake of assuming that their company’s growth rate would forever exceed that of the U.S. economy, yielding sizable yet unrealistic valuations.) Two primary methods are used for assigning a terminal value: (1) perpetual growth, which assumes that the target’s free cash flow will grow indefinitely at a given rate, and (2) exit multiples implied by comparable company or transaction multiples described in previous sections.
Perhaps the most crucial concept of the discounted cash flow valuation method is that of a discount rate. As future free cash flows will occur in the future and the target business is being valued today, it is necessary to adjust future inflows of capital to today’s dollars. This discount rate encapsulates the idea the money today is worth more than money in the future. If given the choice between $100 today and $100 two years from now, most people would choose the former, as they would have the opportunity to invest that money and would reasonably expect to receive more than $100 after two years has passed. This same concept, the time value of money, is used to apply an appropriate discount rate to the future free cash flows and the terminal value of a target business.
Finally, after discounting all future cash flows to today’s dollar, the target company’s cash flows can be summed to yield a final implied valuation. Unfortunately, like the other valuation methods described, the DCF valuation method has its flaws—the most prominent being that it is grounded in assumptions and financial projections that are prone to human error.
Smaller, closely held businesses have historically been more difficult to value because of the following informational challenges and risks, which in turn result in lower valuations. Smaller firms, in general, present certain “information risks” that make valuation more difficult because of:
Lack of externally generated information, including analyst coverage, resulting in a lack of forecasts
Lack of adequate press coverage and other avenues to disseminate company-generated information
Lack of internal controls
Possible lack of internal reporting
In addition, there are numerous firm-specific reasons why small firms are more difficult to analyze from a valuation perspective, such as:
Inability to obtain any financing or reasonably priced financing
Lack of product, industry, and geographic diversification
Inability to expand into new markets
Lack of management expertise
Higher sensitivity to macro- and microeconomic movements
Lack of dividend history
More sensitivity to business risks, supply squeezes, and demand lulls
Inability to control or influence regulatory activity and union activity
Lack of economies of scale or cost disadvantages
Lack of access to distribution channels
Lack of relationships with suppliers and customers
Lack of product differentiation or brand name recognition
Lack of the deep pockets necessary for staying power
Because investors in private companies assume a higher degree of risk, they expect higher rates of return than they would from investments in public-company securities. As a result, private-company valuations tend to be lower. This discount, known aptly as the private-company discount, can range from 20 percent to 50 percent and depends on the type of business and the numerous factors outlined previously. While the selling company can estimate what the discount will be based on assumptions of the acquirer’s perceived risk, the actual discount cannot be determined until a transaction is consummated.
While the detailed methods of valuation described in this chapter can provide a decent starting point for estimating the price at which a transaction will occur, unfortunately, that is often all that they provide. The final negotiated price can vary widely and is dependent on diverse factors, including market conditions, the timing of the negotiations and the valuation date, the internal motivation and goals of both the buyer and the seller, the operating synergies that will result from the transaction, the structure of the transaction, and other factors that may not even be defined explicitly. When all is said and done, only a consummated transaction will provide a 100 percent accurate valuation.