April 16, 2013

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Valuation Techniques For M & A. Is There A Silver Bullet?

- Bikram Mahajan, Vice President [ Bay Capital ]

Bikram Mahajan

In over a 100-page M&A shareholder agreement, perhaps as little as a single line of text is usually devoted to the transaction price, undermining the amount of work and analysis that goes into that line, simplicity masking a huge complexity in determining the price, often conveying the misleading impression that valuation is both easy and accurate.

It is a cliché, but valuation, like so many other constituents of an M&A transaction, is both an art and a science. The beauty of deal making is that both buyers and sellers can win - it is not a zero-sum game. Perhaps this alluring conjecture has been driving the market of corporate control for several years. However, adverse things may happen to uninformed parties, sellers resorting to a distress sale during an economic downturn and buyers suffering the winner's curse in a bull market, making a deep understanding of the value critical in mergers and acquisitions for value-maximization.

Besides a misalignment of buyer and seller expectations, global economic uncertainty also complicates the valuation process, placing considerable stress on the operational, financial and strategic initiatives of most companies. In addition, companies face severe liquidity concerns, wavering consumer demand and difficult supply-chain relationships, making current performance unpredictable and future projections clouded with ambiguity. Despite valuation, at best, being an educated guess, frameworks and tools are available to minimize the margin of error in valuations, so that M&A transactions can succeed for both buyers and sellers.

Which "Value" to value in the M&A World

The disconnect between the world of formal valuation where businesses are valued for courtroom, litigation, and tax planning, and the M&A world stems from value being a range estimate in the M&A world rather than a point estimate. M&A professionals' conclusion of value is directly impacted by the purpose and the underlying standard of value, each company's range of value discernible in the form of a continuum. On the very low end of the continuum is the liquidation value, which is the net amount that would be realized if the business is terminated and the assets are sold piecemeal. Liquidation can be either "orderly" or "forced."

Thereafter, comes the critical concept of "Fair Market Value" (FMV), which is the price, expressed in terms of cash equivalents, at which a business would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

The FMV begins with the minority shareholder's interest in the company who has no control over the company and is not free to exit the company unless the company is listed. The value then moves to the controlling shareholder who has control over management and has the ability to sell the company if he so chooses. Thus, lack of control and lack of marketability are no longer applicable. In an efficient market devoid of buyer- seller information asymmetry, in which both the buyer and the seller have access to the same information, the FMV would converge to the transaction price the rational seller expects to receive.

In practice, the market for corporate control is inefficient and the buyer may not have access to all relevant information about the economic value of the target. Hence, the FMV becomes the minimum asking price of a value-oriented seller unless the seller has non-financial motives to exit from the business, resulting in the asking price being less than the FMV, for instance, the seller may wish to pass ownership to employees through a management buy-out or a may have a pressing need for cash.

While the FMV is impersonal in nature, "investment value" reflects the value to a particular buyer based on buyer's circumstances i.e. buyer's information asymmetry. It includes the value that a buyer anticipates to create through anticipated synergies. The investment value continuum begins with the "financial buyer" or the private equity investor, who does not expect any synergies and attributes the FMV solely to the target, followed by the "non-strategic industry buyer", operating in the same industry as the seller but without a strategic M&A plan, willing to consider an acquisition albeit only at a rockbottom price.

The value then moves to the "portfolio buyer" who may be seeking nonoperating synergies like incremental borrowing capacity or cost reduction through portfolio augmentation. Then there is the "strategic industry buyer" quintessentially seeking economies of scale, entry into new markets, and other strategic synergies to be realized through M&A, and consequently willing to share the value of these synergies with the seller.

At the top of the continuum, with perhaps the highest investment value, is the "roll-up buyer", busy identifying a highly fragmented industry, acquiring scores of companies within it, combining them into one company, and eventually selling it into the public market through an IPO. Value of synergies in a transaction can be captured by either the buyer or the seller, or usually a combination of the two.

The transaction price usually lies between the FMV and the investment value. The difference between the transaction price and the FMV is called acquisition premium and is the gain to the sellers whereas the difference between the investment value and the transaction price is the gain to the buyers. Thus, value is created for shareholders of the buyer only when the value of synergies exceeds the premium paid for acquisition.

Valuation Approaches

The body of business valuation knowledge has established three primary approaches to value businesses to account for companies' variability in the nature of their operations, the markets they serve and the assets they own. Knowing when and how to apply each valuation framework, each with its strengths and weaknesses, is the art of M&A valuation.

According to the International Glossary of Business Valuation Terms, the "income approach" is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount. The "market approach" is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.

Finally, the "asset approach" is a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities. Further, valuation methods are nested within these approaches. The income approach employs two methods: "discounting" i.e. all expected future economic benefits of a company's operations are projected and discounted back to a present value and "capitalizing" i.e. a single benefit is divided by a capitalization rate to arrive at a present value.

The market approach also applies two elementary methods: "guideline company" method, which determines value based on the price at which similar companies are traded on public stock exchanges and the "guideline transaction (M&A)"method which determines prices paid to acquire a controlling interest in similar companies. Within the asset approach, prevalent methods are the "adjusted net asset" method, which estimates the value of the company as the difference between the value of assets and the value of liabilities and the "excess earnings (hybrid)" method, which involves valuing all the tangible assets at current fair market values and valuing intangible assets by capitalizing excess earnings.

The asset approach is predominantly used when the buyer’s primary goal is to acquire specific assets of the target e.g. assets in capital-intensive industries. This approach is often applied by opportunistic buyers seeking distressed owners who are compelled to sell under adverse circumstances. The market approach is often used in M&A because of its ease and simplicity, based on the "principle of substitution". one shall pay no more for an asset than the cost of acquiring an equally desirable substitute, determining value based on prices paid for similar items in the relevant marketplace.

The M&A method reveals prices paid by wellinformed strategic buyers to acquire controlling interest in companies similar to the target. The guideline company method reveals the FMV on a marketable basis, reflecting the price paid by financial buyers. Each of the comparable companies should be evaluated carefully for similarity to the target in terms of size, products, markets served, operations, and financial attributes. A variety of multiples or ratios can be applied to compute the target’s value with either method.

Theoretically, the income approach is the most valid way to measure the value of a business. Income approach is essentially employed by buyers who need to estimate the investment value of the future business earnings they are buying which includes effects of the target's growth and the synergies perceived by the buyers. Synergies, having built a reputation as being the most mythical element in M&A transactions, must be harshly contested, accurately forecasted, and appropriately discounted cash flows that reflect their probability of success under carefully constructed and reviewed time schedules.

However, income approach is more complex because it requires information on a number of factors, including the target's normalized earnings estimates, cost of capital, investment requirements, and likely growth in revenue and profits. Ultimately, scrutiny of the underlying assumptions in any M&A valuation is crucial especially related to the quality, relevancy and accuracy of information.

Wherever possible, all three approaches should be employed to determine a range estimate of a target's value. One or more of these approaches may be more appropriate because of the nature of the transaction or quality of information available. Consequently, it is quite common that one approach is used as the base value and others are used as a check to value.

Adjustments to M&A Valuation

There may be a need to apply several critical adjustments to the valuation estimates derived by applying the relevant valuation approach or a combination of approaches. A control premium is applicable to a controlling interest in the target reflecting the increase in value that is provided through the benefits of control. Similarly, a lack of marketability discount reflects the diminution in value resulting from the inability to promptly convert an ownership interest into cash.

A common error in M&A valuation is to apply a discount or premium based on the characteristics of the target. The correct methodology is to identify the nature of the value initially computed by each valuation approach. Each valuation approach may generate different characteristics of value regarding degree of control and marketability of the valued interest. The M&A method typically results in a control marketable value, while the guideline company method generates a control or non-controlling, marketable value.

The income approach can generate a range of values, with different levels of controllability and marketability, and the asset approach, like the M&A method, usually computes a control marketable value. The key is to analyze the resultant value from each method to determine the adjustments required for control or lack of control and/or for marketability or lack of marketability. Since marketability is influenced by control, the adjustment for the degree of marketability should be made after the adjustment for control.

Although a formal valuation of the target is a vital component of any M&A transaction, valuation alone typically does not drive the terms and pricing of the transaction. The final negotiated price can vary widely and is dependent on diverse factors, including market conditions, M&A process (bilateral vs. auction), motivation and goals of both the buyer and the seller, expected synergies, deal structure, timing (earn-outs) and currency of payment (stock vs. cash), and other qualitative factors.

All said and done, only a consummated transaction provides a hundred percent accurate valuation. Nonetheless, there is an unambiguous utility in the exercise of valuation in an M&A transaction because both buyers and sellers use these tools to gain an insight into whether their perception of value is likely to intersect the other party's perception of value.

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