Updated: May 17, 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.