Valuation for M&A: Building Value in Private Companies / Edition 1 available in Hardcover
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The only resource available to help calculate investment value versus fair market value
Whether buying or selling, the question of "what's it worth?" is multifaceted. In an M&A setting, it is necessary to compute fair market value, but it is far more important to compute investment value-the value of the target company to a strategic buyer. This calculation varies with each prospective buyer, depending on synergies, benefits, and other competitive analyses that are seldom involved in business valuation. Valuation for M&A is the first book to focus on valuation for merger and acquisitions. This groundbreaking guide provides document request checklists, sample interview questions, a format for adjusting financial statements, a format for developing discount rates, a format for computation of net cash flow, and a valuation reconciliation form, all to help senior executives and M&A professionals better negotiate a successful deal.
Frank C. Evans is a certified business appraiser (CBA), Accredited Senior Business Appraiser in Business Valuation (ASA), and CPA (accredited in business valuation) and David M. Bishop is a Master Certified Business Appraiser (MCBA), Accredited Senior Business Appraiser in Business Valuation (ASA), Fellow of the Institute of Business Appraisers (FIBA), and Business Valuator Accredited for Litigation (BVAL).
About the Author
FRANK C. EVANS, a principal in Smith Evans Strimbu, Valuation Advisory Services, is a Certified Business Appraiser (CBA), an Accredited Senior Appraiser in Business Valuation (ASA), and a Certified Public Accountant/ Accreditedin Business Valuation (CPA). He works with middle market through Fortune 100 companies and has spoken at valuation seminars and conferences throughout North America and Europe. He is Editor of Business Appraisal Practice, published by the Institute of Business Appraisers, and has authored numerous articles. He is the recipient of several prestigious awards, including admission to the College of Fellows of the Institute of Business Appraisers. He can be contacted at fevans@SESValuations.com
DAVID M. BISHOP, a Master Certified Business Appraiser (MCBA), Accredited Senior Appraiser in Business Valuation (ASA), Business Valuator Accredited for Litigation (BVAL), and a charter member of the College of Fellows of the Institute of Business Appraisers, is President of American Business Appraisers, Inc. He is one of America's best-known writers and speakers on the valuation of businesses for M&A, value enhancement, and tax-related valuations; his practice concentrates on these types of assignments. He can be contacted at firstname.lastname@example.org
Read an Excerpt
Valuation for M&ABuilding Value in Private Companies
By Frank C. Evans David M. Bishop
John Wiley & SonsISBN: 0-471-41101-9
Chapter OneWinning through Merger and Acquisition
Buyers and sellers can create a lot of value through merger and acquisition (M&A). Both can win from a transaction. That is the beauty of dealmaking. And that is much of the allure that has driven the tremendous volume of M&A activity in the United States during the 1990s; in recent years this trend has extended worldwide.
This book focuses on business value-what creates it, how to measure it, how to build it, and how to maximize it in merger and acquisition. These concepts are equally important to buyers and sellers because both can and should benefit from a deal. But different results frequently occur. Sellers may sell under adverse conditions or accept too low a price due to lack of preparation or knowledge. And every buyer runs the risk of purchasing the wrong business or paying too much. That is why understanding value-and what drives it-is critical in merger and acquisition.
Wise shareholders and managers do not, however, confine their focus on value to only M&A. Value creation drives their strategic planning and, in the process, creates focus and direction for their company. Their M&A strategy supports and complements their broader goal of building shareholder value and they buy and sell only when the deal creates value for them.
This brings us back to the purpose of this book. It explains how to create, measure, and maximize value in merger and acquisition in the context of the broader business goal of building value. Senior managers in most public companies focus on value every day because it is reflected in the movement of their stock price-the daily scorecard of their performance relative to other investment choices. Private companies, however, lack this market feedback and direction. Their shareholders and executives seldom understand what their company is worth or clearly see what drives its value. For this reason, many private companies-and business segments of public companies as well-lack direction and under-perform.
Managing the value of a private company, or a division of a public corporation, is particularly difficult because that value is harder to compute and justify. Yet most business activity-and value creation or destruction-occurs at this operational level.
Being able to accurately measure and manage the value of smaller businesses or business segments is critical in the value creation process. And this skill will pay off in M&A as well because most transactions involve smaller entities. Although we read and hear about the big deals that involve large corporations with known stock prices, the median M&A transaction size in the United States in recent years has been about $25 to $40 million. Smaller deals involving closely held companies or segments of public companies are the scene for most M&A activity.
Therefore, every value-minded shareholder and executive must strive to maximize value at this smaller-entity level where daily stock prices do not exist. The concepts and techniques that follow explain how to measure and manage value on a daily basis and particularly in M&A. The discussion begins with an understanding of what value is.
CRITICAL VALUES SHAREHOLDERS OVERLOOK
When buyers see a potential target, their analysis frequently begins by identifying and quantifying the synergies they could achieve through the acquisition. They prepare a model that forecasts the target's potential revenues if they owned it, the adjusted expense levels under their management, and the resulting income or cash flow that they anticipate. They then discount these future returns by their company's cost of capital to determine the target's value to them. Armed with this estimate of value, they begin negotiations aimed at a deal that is intended to create value.
If the target is not a public company with a known stock price, frequently no one even asks what the target is worth to its present owners. However, the value the business creates for the present owners is all that they really have to sell. Most, and sometimes all, of the potential synergies in the deal are created by the buyer, rather than the seller, so the buyer should not have to pay the seller for the value the buyer creates. But in the scenario just described, the buyer is likely to do so because his or her company does not know what the target is worth as a stand-alone business. Consequently, the buyer also does not know what the synergies created by his or her company through the acquisition are worth, or what the company's initial offer should be.
Sellers are frequently as uninformed or misinformed as buyers. Many times the owners of the target do not know if they should sell, how to find potential buyers, which buyers can afford to pay the most to acquire them, what they could do to maximize their sale value, or how to go about the sale process. After all, many sellers are involved in only one such transaction in their career. They seldom know what their company is currently worth as a standalone business, what value drivers or risk drivers most influence its value, or how much more, if any, it would be worth to a strategic buyer. Typically none of their team of traditional advisors-their controller, outside accountant, banker, or attorney-is an expert in business valuation. Few of these professionals understand what drives business value or the subtle distinction between the value of a company as a stand-alone business versus what it could be worth in the hands of a strategic buyer.
The seller could seek advice from an intermediary, most commonly an investment banker or business broker. But these advisors typically are paid a commission-if and only if they achieve a sale. Perhaps current owners could achieve a higher return by improving the business to position it to achieve a greater value before selling. This advice is seldom popular with intermediaries because it postpones or eliminates their commission.
With sound advice so hard to find, sellers frequently postpone sale considerations. Delay is often the easier emotional choice for many entrepreneurs who identify personally with their company. But with delay, opportunities are frequently lost. External factors, including economic, industry, and competitive conditions that may dramatically affect value, can change quickly. Consolidation trends, technological innovations, or regulatory and tax reforms also can expand or contract M&A opportunities and value.
Procrastination also can hamper estate planning and tax strategies because delays reduce options. And the bad consequences are particularly acute when value is rapidly increasing.
Thus, buyers and sellers have very strong incentives to understand value, manage what drives it, and track it to their mutual benefit.
STAND-ALONE FAIR MARKET VALUE
With a proper focus on maximizing shareholder value, buyers and sellers begin by computing the target company's stand-alone fair market value, the worth of what the sellers currently own. This value reflects the company's size, access to capital, depth and breadth of products and services, quality of management, market share and customer base, levels of liquidity and financial leverage, and overall profitability and cash flow as a stand-alone business.
With these characteristics in mind, fair market value is defined by Revenue Ruling 59-60 of the Internal Revenue Service as "... the amount at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts."
Fair market value includes the following assumptions:
Buyers and sellers are hypothetical, typical of the market, and acting in their own self-interest.
The hypothetical buyer is prudent but without synergistic benefit.
The business will continue as a going concern and not be liquidated.
The hypothetical sale will be for cash.
The parties are able as well as willing.
The buyer under fair market value is considered to be a "financial" and not a "strategic" buyer. The buyer contributes only capital and management of equivalent competence to that of the current management. This excludes the buyer who, because of other business activities, brings some "value-added" benefits to the company that will enhance the company being valued and/or the buyer's other business activities, for example, being acquired by other companies in the same or a similar industry. Also excluded is the buyer who is already a shareholder, creditor, or related or controlled entity who might be willing to acquire the interest at an artificially high or low price due to considerations not typical of the motivation of the arm's-length financial buyer.
The seller in the fair market value process is also hypothetical and possesses knowledge of the relevant facts, including the influences on value exerted by the market, the company's risk and value drivers, and the degree of control and lack of marketability of that specific interest in the business.
Investment value is the value to a particular buyer based on that buyer's circumstances and investment requirements. This value includes the synergies or other advantages the strategic buyer anticipates will be created through the acquisition.
Fair market value should represent the minimum price that a financially motivated seller would accept because the seller, as the owner of the business, currently enjoys the benefits this value provides. The controlling shareholder in a privately held company frequently possesses substantial liquidity because he or she can harvest the cash flow the company generates or sell the company. The lack-of-control or minority shareholder generally possesses far less liquidity. As a result, the value of a lack-of-control interest is usually substantially less than that interest's proportionate ownership in the value of the business on a control basis.
Prospective buyers who have computed stand-alone fair market value should also recognize that this is the base value from which their negotiating position should begin. The maximum value the buyer expects to create from the deal is the excess of investment value over fair market value. So any premium the buyer pays above fair market value reduces the buyer's potential gain because the seller receives this portion of the value created.
Sellers frequently are motivated by nonfinancial considerations, such as their desire to pass ownership of the company on to their children, or, if they work in the company, to retire or do something else. When these nonfinancial considerations exist, it is particularly important for shareholders to understand the financial effect of decisions made for personal reasons. Opportunistic buyers can take advantage of sellers, particularly those who are in adverse personal circumstances. Once again, this fact stresses the need for a continual focus on value and implementation of a strategic planning process that routinely considers sale of the company as a viable option to maximize shareholder value. This process accommodates shareholders' nonfinancial goals and provides the time and structure to achieve them and manage value as well.
INVESTMENT VALUE TO STRATEGIC BUYERS
The investment value of a target is its value to a specific strategic buyer, recognizing that buyer's attributes and the synergies and other integrative benefits that can be achieved through the acquisition. Also known as strategic value, the target's investment value is probably different to each potential buyer because of the different synergies that each can create through the acquisition. For example, one buyer may have a distribution system, product line, or sales territory in which the target would fit better than with any other potential buyer. Generally this is the company to which the target is worth the most. Well-informed buyers and sellers determine these strategic advantages in advance and negotiate with this knowledge.
The difference between fair market value and investment value is portrayed in Exhibit 1-1, which shows an investment value for two potential buyers. The increase in investment value over the company's fair market value is most commonly referred to as a control premium, but this term is somewhat misleading. Although the typical buyer does acquire control of the target through the acquisition, the premium paid is generally to achieve the synergies that the combination will create. Thus, this premium is more accurately referred to as an acquisition premium because the primary force driving it is synergies, rather than control, which is only the authority necessary to activate the synergy.
The obvious questions this discussion generates are:
Why should a buyer pay more than fair market value?
If the buyer must pay an acquisition premium to make the acquisition, how much above fair market value should the buyer pay (i.e., how large should the acquisition premium be, either as a dollar amount or as a percentage of fair market value)?
Chapter 4 summarizes statistics that indicate that the mean and median acquisition premiums for purchases of public companies in the United States have been about 40% and 30%, respectively, over the last 10 years. These figures are not presented as a guideline or as a target. Premiums paid are based on competitive factors, consolidation trends, economies of scale, and buyer and seller motivations; facts that again emphasize the need to thoroughly understand value and industry trends before negotiations begin. For example, a company with a fair market value of $10 million has a much stronger bargaining position if its maximum investment value is $20 million than if it is only $12 million. To negotiate the best possible price, however, the seller should attempt to determine what its maximum investment value is, which potential buyer may have the capacity to pay the most in an acquisition, and what alternatives each buyer has, and then negotiate accordingly.
Generally speaking, buyers should begin their negotiations based on fair market value. Before they enter the negotiation process, where emotional factors and the desire to "do the deal" take over, buyers should establish their walk-away price. This is the maximum amount above fair market value that they are willing to pay to make the acquisition. Establishing the maximum price in advance encourages buyers to focus on value rather than on "winning" the deal. Naturally, the farther the price moves above fair market value toward that buyer's investment value, the less attractive the deal becomes.
Excerpted from Valuation for M&A by Frank C. Evans David M. Bishop Excerpted by permission.
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Table of Contents
Winning through Merger and Acquisition.
Building Value in a Nonpublicly Traded Entity.
Merger and Acquisition Market and Planning Process.
Valuation Approaches and Fundamentals.
Income Approach: Using Rates and Returns to Establish Value.
Cost of Capital Essentials for Accurate Valuations.
Weighted Average Cost of Capital.
Market Approach: Using Guideline Companies and Strategic Transactions.
Adjusting Value through Premiums and Discounts.
Reconciling Initial Value Estimates and Determining Value Conclusion.
Art of the Deal.
Measuring and Managing Value in High-Tech Start-Ups.
Merger and Acquisition Valuation Case Study.