Acquisition Valuation (#75)
/In this podcast episode, we discuss the many variations on how to value a business, as well as the expectations of the buyer and seller. Key points made are noted below.
When a buyer is interested in acquiring another company, how does it place a value on the target?
Valuation Based on Market Value
The easiest valuation method only applies to targets that are publicly held. Since investors have already established a market price for the stock, the buyer and seller can both figure out the total market value pretty easily, and then it’s just a matter of negotiating a premium over that price, which is called a control premium. Buyers are willing to pay a control premium, because of course, they gain control over the target company, and can then impose a variety of synergies to increase cash flow – and we’ll talk about synergies in a future episode.
Valuation Based on a Multiple of Revenue
Another option is to use a multiple of revenue to arrive at the price. It’s easy to come up with revenue multiples for comparable transactions, because there are acquisitions going on all the time, and the purchase price and target company revenues are frequently available in press releases. Now keep in mind that these multiples should be based on recent acquisitions within the same industry, because they fluctuate quite a bit over time, and vary enormously by industry. There will also be some outliers among those comparable transactions – maybe someone accepted a low price because they were in a cash squeeze, or maybe someone else got a high price, because they had some really good intellectual property. You generally want to throw out the outliers.
Basing a purchase price on a revenue multiple is a good idea when the target company is growing really fast, because it may not yet have much proven profitability - if any. This leaves you with really no other methodology to choose from.
But, the problem with the revenue multiple is that it only pays attention to the top line of the target company’s income statement. It could be suffering from horrible cash flow, and so isn’t really worth anything. This can really be a problem when an industry starts to consolidate; a common scenario is that a prime target company, with excellent financial results, is acquired first, and the transaction has a really high revenue multiple.
Then other buyers pile into the market, and are met by sellers who see that one massive revenue multiple hanging out there, and they want a similar price. The trouble is that only the first target was actually worth that kind of money. This means you have a disconnect on the part of the sellers, who think they’re worth more than they really are.
Valuation Based on a Multiple of Profit
A solution to the problems caused by the revenue multiple is the profit multiple. This is the purchase price divided by the profit for comparable companies that have been acquired. This works much better, but the information for comparables is quite a bit leaner. If you choose to work through an investment banker, they should have access to comparables databases that contain this information, and they can give you a pretty tight cluster of comparables to work with.
Valuation Based on Cash Flows
A variation on the profit multiple is the gold standard of valuation, which is to use a multiple of cash flows. There are a lot of ways to manipulate net profits to make a company look unusually profitable, but it’s another story with cash flow. Either a target company churns out cash, or it doesn’t. So, a conservative, experienced buyer usually wants to derive a valuation based on comparable multiples of cash flow for related acquisitions.
Downward Valuation Adjustments
No matter which one of these models you use, you also need to make a number of downward adjustments, such as for the cost of completing the acquisition, for a possible loss of customers, severance expenses for anyone being let go, upcoming fixed asset replacements, for pension funding, and so on.
Other Valuation Approaches
Now, there are also ways to value a target company that don’t use financial statements at all. For example, what if the target company has spent several years developing a really neat product? If the buyer thinks there’s a short time period for getting its own competing product to market, and it isn’t going to make that deadline, then it can put a value on the target’s competing product, and buy the whole company just to get its hands on that product. This is obviously a special situation, and you don’t see it very much.
There’s also a super conservative approach when you’re looking at buying a company that’s a complete dog. Its only real asset may be the underlying value of any real estate that it owns. In that case, the buyer appraises the real estate and other assets, and basically ignores the business.
The Valuation Time Line
So, there we have some valuation methods. The next problem is, over what time period do we apply the valuation? The safest and most conservative approach is to value either a target’s revenues, profits, or cash flows based on its audited results for its last fiscal year. By using an audit, you have some assurance that the numbers are real.
However, a target that has improving results wants to use its trailing 12 months of results, some of which may be audited, and some of which may not. The buyer can certainly agree to a trailing 12 valuation, but should include a clause in the purchase agreement that some of the purchase price will be placed in escrow, subject to an audit of the results of those 12 months.
The next scenario is the hard one – what if the target company claims that its upcoming sales will be astronomical, and so wants to be valued based on results that haven’t even happened yet? I see this one all the time. Some buyers offer additional compensation if future results actually do increase, which is called an earnout. The problem is that, if results don’t increase – which is to say, most of the time – the former owners of the target company claim that the buyer interfered with their activities, and take the buyer to court. The result is usually that the buyer ends up paying extra. In short, promising payments that are contingent on future performance is usually a bad idea. If you insist on following that path, then budget for the maximum earnout payment, because that’s probably what you’ll end up paying.
Dealing with a Range of Valuations
It sometimes makes sense to calculate some or all of these valuation methods, and see what kind of a range of possible prices you end up with. The real estate valuation method should yield the lowest price, while the revenue multiple is probably at the top. Your negotiation range will be inside of these two prices.
Factoring Synergy Gains Into a Valuation
But. There is one more factor to consider, which is synergy gains. The buyer should have a list of possible synergies that it expects to obtain – things like increased revenues from combining sales territories, or reducing duplicate overhead expenses. If the target company is smart, it will negotiate for a piece of those gains, by getting a higher up-front price.
For example, the basic valuation analysis may show a likely price of $10 million, and an additional savings to the buyer of $2 million from subsequent synergies. A really sharp seller will negotiate not only for the $10 million, but also a piece of the $2 million.
Dealing with Seller Expectations
The real problem with determining an acquisition value is that the seller’s expectations are too high, so it demands much too high a price. Sometimes a price that’s hysterically high, especially in comparison to what the buyer is willing to pay. The reason for the difference is that buyers are frequently serial buyers – they do a lot of acquisitions, and so they have a good methodology in place for creating a valuation. This is not the case with the seller, which may never have been involved in such a transaction before, and so has no experience with valuations.
The usual sequence of events that I’ve seen – many times, almost always – is that you approach a potential target about an acquisition, and they respond with a price that is too high, either because of inexperience with valuations, or because they think the business is about to expand dramatically in just a few more months.
When you run into this massive difference in price, just politely walk away, and be prepared to wait a few years for reality to strike the target, and for the price to come down. I’ve found – nearly 100% of the time – that if you wait long enough, the target eventually contacts you, and is willing to accept a much lower price.