The perception of value sits at the center of any corporate transaction. The exchange of equity for cash must be balanced for a fair transaction to occur, and as a result there are a multitude of questions important to answer in advance of negotiations. Ultimately, valuation is the estimation of worth based on many factors including company management, capital structure, future earnings and asset value.
While entrepreneurs often consider the future potential of their companies, investors can view value based on milestones already achieved. Since investor returns lie squarely in the difference between the current and future values of their investment, these disparate views can often lead to difficult negotiation. Investors and entrepreneurs are well-served to identify a valuation that provides adequate compensation for the risk inherent in each transaction.
Buyers and sellers often have different motives and thus different questions to answer.
Buyers can be strategic or financial:
Strategic buyers can take a long time to assess synergies and are often interested in paying a significant premium for these synergies. These buyers are also unlikely to retain existing personnel as operational synergies drive decision making. Their goals may include geographic expansion, enhanced scale, expanded product offerings, pricing power, intellectual property control and key supplier/customer retention.
Financial buyers focus on their projected return on invested capital. Management teams are more likely to be left intact, and while target companies are inherently healthy their valuations are often temporarily depressed for sector or macro reasons. Financial buyer’s goals revolve around acquiring assets at cheap prices to resell them at a premium during a normal business cycle.
Seller questions include:
- Does the management want to remain in the NewCo?
- What is the desired time-frame for transaction completion?
- What are the tax ramifications of the transaction?
- What is the best currency for the deal?
- Is there a preference between an open auction and a discreet negotiation?
While parties can assume different forms of valuation analysis, it is generally healthy to utilize a variety of methodologies to triangulate back to a valuation that is defensible from multiple perspectives.
Common valuation methodologies:
Comparable company analysis: This methodology is based on the premise that companies in the same industry that have similar characteristics are valued in a similar fashion. Common valuation measures include ROA, ROE, P/E, P/B, EV/Sales and EV/EBITDA.
Precedent transaction analysis: When the peer group available for comparison is limited, recent transaction in a similar sector can provide some basis. This technique has limitations, especially in industries that contain oligopolies or offer few precedent transactions.
Discounted Cash Flow analysis: This methodology is based on the assumption that over time a target company can be valued on the present value of its projected free cash flows (FCF). One must project the amount of operating FCF the company is likely to produce over a selected time-frame, and then discount these along with terminal value using the company’s weighted average cost of capital (WACC).
Pro-Forma analysis: Hypothetical financial statements assuming a consummated transaction are created to compare the cost savings and other financial benefits to a proposed combination. This method is known as recasting, and factors considered include headcount reductions, pricing power changes, facility closures, combined tax status, changes in WACC and revenue synergies.
Leveraged Buyout analysis: Since an LBO transaction generally alters the target company capital structure, this analysis includes pro-forma projections using post-acquisition assumptions. A DCF valuation is then conducted to determine if the proposed price and exit valuation contribute to an adequate return on invested capital.
Pre-revenue companies could also consider a variety of other valuation methodologies, including:
- Bill Payne method
- Berkus method
- Venture Capital method
- Risk Factor Summation method
Transactions can occur in cash, in equity with a fixed share or fixed value agreement, or as a combination. A cash offer provides a known value, limits dilution, creates immediate tax liability and is often made at a discount to an all-stock deal. A stock offer generally carries an unknown value, postpones tax liability, is dilutive and often carries a premium to an all-cash deal. Collar agreements and material adverse effect clauses are often used to mitigate some of the risk inherent in these transactions.
It remains important to remember that because we tend to value those metrics we can measure most accurately, we are often precisely wrong rather than approximately right. Ultimately, the value of a firm is a function of three variables—its capacity to generate cash flows, its expected growth in these cash flows, and the uncertainty associated with these cash flows.