Updated: Jun 30, 2021
Selling a business at the maximum possible value, may seem difficult and daunting. It is however, certainly not an impossible task, provided we fully understand what drives the value of a business and then present our business to the potential buyers/investors in a best possible fashion. In other words, with proper planning & execution, achieving the goal of maximization of value is not necessarily a very difficult goal.
First thing which we need to understand about business valuation is the fact that it is not exactly a science. In practice, it is more of an art than science.
Fortunately however, there are proven models and frameworks that could drive valuation to maximum levels and lead to successful M&A deals. This article is intended to help provide some guidance to companies as well as entrepreneurs that are contemplating a sale of their businesses. Reading through should add to your understanding of what are the primary and secondary valuation drivers in a M&A (mergers & acquisitions) sale process.
LET US BEGIN AT THE VERY BASICS
What is the M&A process?
The mergers and acquisition ("M&A") process is a transaction between the owners of companies and their constituent assets and the investors i.e. the buyers of a business. It comprises a range of activities that involve strategy, valuation, negotiation, and the combining of corporate assets with the intent of upholding and increasing business value.
Unlocking the drivers of value
To understand this at a very basic level (which actually is the most important level), we can begin by looking at the the DCF (discounted cash flow) growing perpetuity formula to unlock the fundamental drivers of value.
We all know that the value of a business is most often described/understood in the terms of:
The present value of the free cash flows that it is likely to generate in the future.
Therefore, looking at the formula above, we can deduce the following at the very outset:
1. If free cash flows that a business generates go up, the value of that business goes up.
2. If the rate of growth of a business goes up, the value of that business goes up.
3. If the cost of capital of a business goes up, the value of that business goes down.
4. If the rate of growth of a business goes down, the value of that business goes down.
Drivers of value and price in a bit more detail
This value, which we normally (more often than not) derive by discounting future cash flows (as shown above) represents the intrinsic value of a business i.e. the value of that business as a stand-alone business going on into Perpetuity (if that was theoretically possible). This however, is not necessarily the value at which a potential acquirer will be willing to acquire this business. Other than the intrinsic value of the business, the factors that will impact an investor's decision primarily include the (perception of) existence of possible synergies and the skill with which the seller has positioned the business (acquisition target).
Given below is a diagram showing the convergence of many forces in determining the selling price of a business.
How buyers estimate if an acquisition is going to add value for them?
Potential buyer begin by looking at the intrinsic value of the business i.e. what is the business worth as a stand alone entity. Then they estimate hard synergies i.e. the cost savings which they expect to realize as a result of this acquisition. Such cost savings are expected to be achieved mainly through achievement of economies of scale and elimination of certain duplicate cost heads (mostly related to support or admin functions).
This is followed by an estimation of the financial impact of the likely soft synergies i.e. the revenue enhancements which are likely to occur as a direct result of acquisition. Such enhancements in revenue could occur due to elimination of competition or due to the effects of forward or backward integration.
On top of that, the impact of any financial synergies is estimated. Financial synergies could occur in the form of either better access to capital (as a direct result of acquisition) or lowering of the cost of capital (for instance lower borrowing cost due to much larger size of the organization post acquisition). Transaction costs (cost associated with the acquisition transaction) are then reduced from the total estimated value of synergies to arrive at net synergies.
As long as the combined value of the intrinsic value and net synergies is in excess of the price/consideration paid to the seller, a buyer would consider that value has been created.
So the target of an investor who is acquiring a business is to make the orange box shown in the above diagram as big as possible.
WHAT ARE THE PRIMARY AND SECONDARY VALUATION DRIVERS OF A BUSINESS?
Premium valuation i.e. a valuation which is well in excess of a company’s current valuation (if publicly traded) or in excess of the company’s peer group on a relative basis (if privately held) is achieved through a combination of the right positioning of the company/investment opportunity and an effective M&A sale process.
The percentages featured in the above info-graphics are illustrative of a typical M&A sale process. In practice, each transaction and subsequent outcomes are unique and can vary significantly depending on a variety of factors.
Understanding the Positioning of a Business
As mentioned earlier, achieving higher business valuation for M&A purposes is more art than science. i.e. Properly positioning an acquisition opportunity to the investment community has a major impact on the likely valuation. Optimum positioning is achieved through a variety of forms and deliverables. This includes:
1. Initial investment or company presentation.
2. Initial follow-up calls.
3. Follow-on dialogue and Q&A with interested investors.
4. Management presentations.
5. Subsequent deal and legal negotiations etc.
The positioning process is optimized over the course of a number of months.
Positioning Process Flow
Initially, the financial advisers aim to learn as much about the business as possible in a relatively short amount of time. This is followed by some detailed work to analyse and distill the opportunity into a series of investment highlights that the investor community will find enticing. These investment highlights, along with specific information about the target, will initially be presented to the investors in the form of an investment presentation.
The form and contents of this presentation could vary with each opportunity. However, in general, what these highlights and company information consist of, and how they are presented in the investment presentation fall into two main categories and address the following questions:
1. What is The Intrinsic Value of The Business: i.e. What is the standalone (intrinsic) value of the business based on current operations and growth potential under assumption that the business continues as a separate entity in the foreseeable future?
2. What is The Strategic Value Based on The Expectations of Synergies: i.e. What is the incremental value to the investor, above and beyond the current intrinsic value? This would depend upon the probability of realizing both soft and hard synergies as well as the financial synergies.
Components of The Positioning Valuation Drivers of a Business
Let us now take a detailed look at these components.
Intrinsic Value of The Current Operations
The first element to be highlighted in positioning revolves around the current operations of the business. The financial adviser presents the current operations while striving to highlight the target’s strengths and differentiators. At the same time, also mitigating any potential weaknesses. Depending on the specifics of the opportunity, this can include a collection of the following:
· Current growth, financial performance, and key performance metrics.
· Unique and differentiated product or service highlights.
· Brand reputation and market feedback.
· Existing customer or user base information, trends and statistics.
· Competitive dynamics.
· Management team and strengths.
· Acquisition history.
· Strength of balance sheet.
· Ownership and capitalization.
The financial adviser must also stay consistent with the art/science representation i.e. knowing where to look for key “salable” highlights is both scientific and formulaic. Knowing how to digest and present them to the investor is certainly more artful and more of a moving target, and there is no substitute for deal experience when it comes to effective positioning.
Baseline Intrinsic Value
The baseline intrinsic value can be easily derived through recent trading multiples e.g. identify Enterprise Value/EBITDA for comparable transactions in an industry and then apply those multiples to the current EBITDA of the target.
However, having a deeper understanding of what is driving current and forward EBITDA, and being able to defend this position (both the EBITDA metric itself and what drives it, as well as why the market multiple, or ideally a higher multiple, is adequate and applicable to the target), is crucial to the M&A process. Given that investors make it their livelihood to invest in businesses and given that there is no shortage of deal flow, investors typically have an informational advantage over a business owner or entrepreneur that has done far fewer transactions, and in many cases, is transacting for the first or second time.
Dealing With The Investor's Assertions About Your Assumptions
The investors would invariably raise questions about most material assumptions & estimations in your presentation. For instance, the investors could question the accuracy of CAV (Cost to Acquire a Customer) and CLTV (Lifetime Value of Customer) figures of a privately held business during the management presentation phase. This normally happens during the second phase of the M&A sale process after the initial investor presentation and often requires additional research, preparation, and analysis, in which an adviser must be very well-equipped to help guide the target. In preparation for this second phase, the adviser and his team must be prepared to guide the client towards specific responses in anticipation of these types of questions. Having firm rebuttals prepared serve two purposes:
1- It helps investors with better understand the key areas of the business while also giving them confidence in the opportunity and in the management (thus enhancing the positioning).
2- It also adds to the competitive tension (this is key to running an effective process), one main implication to the investors being that other investors may have already asked similar questions, given management’s fluid, “natural” responses.
Intrinsic Value of The Growth Potential
The second component to properly position the company’s intrinsic value is to highlight the company’s growth potential. Key areas that are addressed can include the following:
· Future growth and growth drivers (organic growth).
· Stability of the business model.
· Untapped or total addressable market opportunity.
· Acquisition or consolidation opportunities (inorganic growth).
Potential for new and/or enhanced growth, in and of itself, is what really whets the investors’ appetite. At the same time, understanding and verifying from where this new growth comes will be a key area of focus for the investor, so the target can expect a good amount of questions and “hole poking.” On one hand, no one truly understands a specific business better than the business owner or entrepreneur.
On the other hand, investors with a track record for both identifying and executing on successful growth opportunities bring years of experience and confidence to the table in terms of assessing a range of potential outcomes and, ultimately, the likelihood of success.
Good financial advisers will guide the company and management toward the right balance of projecting aggressively (science), yet also realistically (art), and will spend a good amount of time fine-tuning, testing, and verifying the assumptions prior to speaking with investors and approaching the market. This primarily serves to arm management with the proper tools, information, and know-how to address potential questions and concerns throughout the process. Additionally, investors love growth and more so when companies exceed projections during a process. This can potentially raise valuation even higher but also lower it if actual performance disappoints. Proper guidance and advice protect against this type of situation.
Properly positioning strategic value to the right investor has the potential to significantly raise valuation during a sale process. In general, there are numerous reasons for a merger or acquisition as it pertains to generating strategic value, or “synergies,” for the investor. These synergies loosely fall into two main categories: integration and diversification.
An adviser will help to highlight and position the relevant synergies with the goal of demonstrating how these relevant synergies are more valuable to the current potential investor than to another buyer, and thus increasing the purchase price.
ach transaction is unique, and more specifically, potential synergies to each potential investor involved in the same sale process may also be different. An adviser's intimate knowledge of the M&A market, the specific sector, and each specific buyer is a great resource to help the company think through, quantify, and present these potential synergies.
An Effective M&A Sale Process Also Drives Valuation
In practice, while launching an effective process is very much a science (efficient timetables, diligent follow-up and preparation, process management, etc.), proper negotiation strategy and execution of this process is very much both art and science. More importantly, an effective process encapsulates the entire transaction, starting with early-stage diligence, proper strategy and positioning, drafting of Investment and management presentations, calls with buyers, and deal and legal negotiations, etc.
Running an effective sales process in real terms is ultimately how value is successfully realized, and there is no substitute for how best to complete a transaction.
Using an illustrative example, a specific company may intrinsically be worth $80 million and may be worth $100 million to a certain subset of buyers (a result of effective positioning). However, in a failed sale process, this same business would realize $0 in value. On the other hand, a successful process can not only lead to valuation higher than $100 million but also lead to full realization of this value. This is primarily achieved by creating a competitive environment and maintaining bidding tension among likely buyers. Further, while competitive tension is designed to drive up value, it also serves the purpose of pushing parties to a close. Deal certainty clearly has value, and having a proven financial adviser that can push deals through closing is paramount in terms of adding value to the process.
Throughout my professional career, I have advised numerous clients in successful deal closings as well as unsuccessful ones. There exist a number of reasons both for why deals fail and for why investors ultimately buy companies, and while maximum M&A valuation is ultimately determined by how much an investor is willing to pay, there also exists a clearly defined road map (science) to successful deal-making.
When combined with proven deal and negotiation experience (art) - competitive tension, effective positioning, and process management are necessary - successful outcomes are likely to be achieved. In conclusion, in every M&A deal in which I have been involved, the decision taken by the business owner to ultimately sell is one of the biggest and most important in their life. Deal-making ultimately comes down to people and relationships, and having a proven and trusted adviser who understands, empathizes with, and values your business should always be top of mind of the seller.
ABOUT THE AUTHOR:
MOHAMMAD KASHIF JAVAID
The writer is an international business consultant. His LinkedIn profile could be viewed at:
You can write to him at firstname.lastname@example.org
To find out about his consulting services, please visit: https://www.acssynergy.com/
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