Acquisition Marketplace Review - The Journal of Applied M & A Theory

Avoiding the Overpayment Trap

The M&A market generally favors the seller and their advisors and is orchestrated to generate the best price and terms for the seller. When was the last time you read an article in the business press that started off with “XYZ Company spends too little to buy a company?” DealSense Plus+, on the other hand, is designed specifically for buyers and their advisors to encourage and assist them in making economically sound acquisitions.

The pricing approach embedded within DealSense Plus+ helps buyers avoid the overpayment trap. The elements of the pricing approach work together so a buyer can evaluate deal price and terms from several different perspectives. The key elements of the pricing approach contained in DealSense Plus+ are summarized below.

    1. Fair Market Value (FMV) from a buyer’s perspective is the most probable price a hypothetical willing buyer (as opposed to a specific buyer) might pay for the stock of the company. It is assumed that a hypothetical willing buyer seeks to obtain a return on the investment that is commensurate with the risk and cost of capital. Factors such as the benefits from synergies and economies of scale are related to a “specific buyer” and should not be considered when preparing the Equity valuation. Fair Market Value provides a baseline for purchase price considerations.

    2. Market Value of Invested Capital (MVIC) is calculated by adding Total Interest-Bearing Debt and any Preferred Stock to FMV. MVIC is included for the benefit of buyers that have comparable data that provides a MVIC multiple for completed transactions (such as Pratt’s Stats). MVIC is sometimes referred to as Deal Price.

    3. Enterprise Value (EV) is calculated by deducting Cash and Equivalents from MVIC. EV is essentially the value of the company as if it had no debt or cash and provides a baseline for considering the purchase price in an Asset Sale. Cash and Equivalents are deducted because a seller typically retains cash reserves in an asset transaction.

    4. Asking Price is the seller’s indication of value and is the starting point for negotiation in most cases. The seller’s Asking Price is usually based upon the sale of either the company’s equity or assets. FMV would be the appropriate value indicator if the seller offers stock or equity. EV would be the more meaningful value indicator for an asset offering. There are instances when a seller does not provide an Asking Price and merely “invites” potential buyers to submit an offer in a negotiated sale or puts the company up for auction. Both of these pricing strategies put the burden of “naming a number” squarely on the shoulders of the buyer.

    5. Asking Price Premium or Discount is the spread between the Asking Price and the value indicators (FMV, MVIC and EV) and suggests whether the seller’s Asking Price is in the ballpark. A Discount (positive spread) indicates that, for whatever reason, the company is priced to sell. The Asking Price Premium (negative spread) is also expressed as a percentage so its reasonableness can be compared to industry data (such as FactSet Mergerstat’s Control Premium Studies).

    6. Proposed Price is the amount of consideration the buyer is willing to pay. The proposed purchase price is allocated between stock or assets, non-compete agreements and executory agreements. The Proposed Price is a negotiated number. Multiples, premiums, discounts and a host of other economic indicators can guide the negotiation, but when the day is done, the buyer wants the Proposed Price to be a number that is acceptable to the seller and economically viable for the buyer. One further caveat, the “economic viability” should be predicated upon reasonable assumptions.

    7. Proposed Purchase Price Premium or Discount is the spread between the Proposed Purchase Price and the value indicators (FMV, MVIC and EV). A Discount might indicate a bargain. A buyer wants to be especially sensitive to any Premium over the value indicator because it can be a risk factor. If the acquisition does not work out and the buyer seeks to divest the company entirely or in segments, there is a chance that the price will be closer to the value indicator. That can result in write-offs and the destruction of shareholder value. Any buyer who offers a significant Premium over the appropriate value should look in the mirror and ask: “If this acquisition doesn’t work out, what are our odds of finding a party that would buy the company for what we’ve invested?”

    8. Proposed Price to Asking Price Spread quantifies the difference between the buyer and seller’s perceptions of value at any given time. A significant Discount on the seller’s Asking Price might signal the need for assertive negotiations to lower the seller’s expectations (if possible) or to explore creative deal structuring and financing strategies. Some buyers bridge the gap with an earn-out provision that make payments contingent upon the attainment of defined performance levels such as Net Revenues, EBITDA or EBT. The definition of the terms of an earn-out provision in the Definitive Purchase Agreement will frequently be negotiated aggressively by the parties’ legal representatives.

    9. Key Price Multiples are automatically calculated by DealSense Plus+ based upon year-end, average, and next year’s project numbers. The multiples are calculated for Asking Price and Proposed Price as well as for FMV, MVIC, and EV. The multiples are based on Net Cash Flow, Free Cash Flow, Net Income, EBT, EBIT, EBITDA, Total Revenues, Interim Book Value, Normalized Book Value and Net Asset Value. The variety of multiples presented will likely cover most buyers’ preferences.

    10. Transaction Type defines what is being purchased (stock or assets). In addition to numerous accounting and legal implications, the type of transaction will impact the investment basis, taxes and the bottom line.

A. In the case of an asset purchase, the acquired business can: (i) go forward as a stand-alone entity, (ii) be absorbed into the buyer’s company as a division or strategic business unit or (iii) be completely folded into the buyer’s operation. Unless assumed, the seller’s liabilities generally do not carry over to the buyer under an asset sale; provided that the provisions of Bulk Sale and other creditor-rights laws have been met.

B. In the case of a stock acquisition, instead of buying the tangible and intangible assets, the buyer is purchasing the stock and therefore inherits all of the assets and liabilities (known and unknown) that come with it.

    11. Transaction Costs typically include fees paid to investment bankers, brokers, attorneys, accountants and other professionals that provide services necessary to initiate discussions, negotiate, perform due diligence and close the transaction. The amount of fees for services (i.e., legal and accounting) can be estimated or budgeted on a fixed-cost basis. Investment banker, broker or finder (intermediaries) fees are usually paid based upon a percentage of the sales price as defined in the engagement letter. The most common fee structure is known as the Lehman Formula and is based upon a sliding scale. DealSense Plus+ allows the user to modify the sliding scale to conform to the terms negotiated with any intermediary they may have engaged.

    12. Purchase Price Allocation plays an important role in determining the timing of after-tax cash flows and related calculations.

A. In an Asset Purchase, the Purchase Price is allocated to the tangible and intangible assets, covenant(s)-not-to-compete, and other executory agreements with any remainder allocated to Goodwill. A schedule has been included in DealSense Plus+ for allocating Intangible Assets as required for GAAP reporting under Statement of Financial Accounting Standards 141.

B. In a Stock Purchase, the Purchase Price is allocated to the Stock or Equities being purchased, covenant(s)-not-to-compete, and executory agreements. A Stock Purchase does not create Goodwill on the books of the acquired company and the existing basis of assets and liabilities generally carries forward.

    13. Purchase Price Distribution to the seller can take the form of cash at closing or other forms of payment. The other forms of payment can include stock, notes payable to the seller, deferred payments on the covenant-not-to-compete and any other executory agreements (performance pending).

    14. Purchase Cost is the sum of the Proposed Price and Transaction Cost (both fixed and variable).

    15. Required Funding is the total amount of cash, debt and equity that the buyer must bring to the closing table to fund the transaction. By deducting the portion of the covenant-not-to-compete that is being carried by the seller along with deferred payments due under executory agreements and, in the case of an Asset Purchase, assumed liabilities, we arrived at the Balance of the Purchase Cost to be Funded. Any additional, discretionary funding for working capital is added to this amount to arrive at the Total Purchase Cost and Discretionary Funding. By deducting seller financing and the value of buyer stock to be tendered, we arrived at the amount of Cash Required at Closing.

        Total Funding Required (all forms)
    -   Deferred Payments on Covenant-Not-To-Compete
    -   Deferred Payments on Other Executory Agreements
    -   Assumed Liabilities (in an asset sale)
    =  Balance of Purchase Cost to be Funded

    +  Additional Discretionary Funding (working capital)
    =  Total Purchase and Discretionary Funding Required
    -   Seller Provided Funding
    -   Value of Buyer Equity
    =  Cash Required at Closing

Sources of cash are outside debt (other than seller) and equity (Common or Preferred). The sources of cash are important because they impact the Cost of Capital component of the Hurdle Rate.

    16. Hurdle Rates are minimum required returns and are used in capital budgeting to determine whether the amount of economic benefit to be derived from a project (or acquisition) is acceptable. In DealSense Plus+, there are two different Hurdle Rates; one for Invested Equity and another for Total Invested Capital (TIC). The Equity Hurdle Rate equals the Cost of Equity plus an additional required return. The TIC Hurdle Rate is the Weighted Average Cost of Capital (i.e. debt and equity) plus an additional required return. Shareholder value is typically not created unless returns on investment (measured using Free Cash Flows) exceed the respective Hurdle Rate.

In determining the Costs of Capital, there are two frequently asked questions:

- Do you use the buyer’s, seller’s or an investment-specific Costs of Capital?

- Do you use the actual Costs or a Market Cost?

The answers to these questions are related and could easily be the subject of another article. The correct answer in any given case is going to depend upon the specific facts and circumstances of a given transaction. The short answer is that the Costs of Capital should be based upon the risk of the investment unless there is a compelling reason to do otherwise. In almost all cases, it is not wise to use the seller’s actual Costs of Capital, especially in a privately held company. In a privately held company, debt financing can be secured with personal guarantees of the owner(s) and pledges of their stock. In addition, an owner’s equity investment can be structured as a loan payable to shareholder. In the valuation portion of DealSense Plus+, the Cost of Capital is estimated by using either the Build-Up or CAPM methods. These methods are based upon market observations rather than Book Values and are effectively “investment-specific.” Since the Cost of Capital is applied to earnings (as a capitalization or discount rate) to determine Price/Value, a decrease in the Cost of Capital will result in an increase in Price/Value. So, by using a project- or investment-specific Cost of Capital, you can also avoid the situation wherein a buyer with a low Cost of Capital pays too much for a riskier company.

    17. Free Cash Flow (FCF) is considered to be one of the best financial measures of value creation. FCF is vastly superior to EBITDA for a host of reasons (see related article) and can be calculated for both Total Invested Capital (TIC) and Equity. Free Cash Flow to Equity (FCF-E) measures the amount of cash that is available to equity holders and is the appropriate earnings base for evaluating returns of Invested Equity. FCF-E is calculated as follows:

        Net Income
    +  Non-Cash Charges (depreciation and amortization)
    -   Capital Expenditures
    -   Changes in Net Working Capital
    -   Changes in Interest-Bearing Debt
    -   Preferred Dividend Payments
    =  Free Cash Flow available to Equity

FCF to Total Invested Capital measures the amount of cash flow available to both debt and equity holders and is the appropriate earnings base for evaluating returns on TIC. FCF- TIC is calculated as follows:

        Net Operating Income (i.e., earnings before interest)
    -   Taxes
    +  Non-Cash Charges (depreciation and amortization)
    -   Capital Expenditures
    -   Changes in Net Working Capital
    =  Free Cash Flow available to Total Invested Capital

Projected FCF-E and FCF-TIC are both used to evaluate a proposed transaction. In the Pricing section, Free Cash Flows from the Pre-Acquisition Projections are adjusted to reflect the impact of price and transaction details. The Adjusted Free Cash Flows are used to provide a validation or test of the Proposed Price prior to proceeding with the discipline of preparing detailed Post-Acquisition Projections. Furthermore, by using Adjusted Free Cash Flows based upon the Pre-Acquisition Projections, the buyer is avoiding the trap of paying the seller for value created by the buyer.

A second set of projected Free Cash Flows is calculated and analyzed using the detailed Post-Acquisition Projections. The Post-Acquisition Projections include the effects of price, transaction terms, funding activities and the impact of any operating changes planned by the buyer’s management. FCF based upon Post-Acquisition Projections do not need to be adjusted because all of the assumptions have presumably been built into the projections.

    18. Present Value (PV) is the value now of an economic benefit that will (may) be received in the future. Projected FCF is discounted for each projected year and added together to the PV of Residual Value of FCF’s. The Hurdle Rate is used as the Discount Rate in the PV calculations. The Residual Value (also called the Terminal value) is arrived at by dividing the Residual Free Cash Flows by the Hurdle Rate less the Long-Term Growth Rate and then discounting that quantity back to PV.

    19. Net Present Value (NPV) equals the PV of Free Cash Flows less the initial investment. The PV of FCF-E is deducted from the initial Invested Equity to arrive at the NPV of Invested Equity. Similarly, PV of FCF-TIC is deducted from the initial Total Invested Capital to arrive at the NPV of TIC. If NPV is a positive value, you have exceeded your Hurdle Rate.

    20. Spread between Hurdle Rate and IRR is determined at by first calculating the IRR for both FCF-E and FCF-TIC. The IRR is then deducted from the respective Hurdle Rate. An IRR that’s greater than the Hurdle Rate would favor the acquisition. The IRR is the Discount Rate that makes the NPV of cash outflows and inflows equal to zero.

    21. Profitability Index is another way to measure the viability of an acquisition at a given price. It is also calculated for both Invested Equity and Total Invested Capital. The Profitability Index on Invested Equity is obtained by dividing the PV of FCF-E by Invested Equity. The Profitability Index on Total Invested Capital is obtained by dividing the PV of FCF-TIC by Total Invested Capital. A Profitability Index greater than (or equal to) one favors the deal. When using the Profitability Index to evaluate alternative investments, it should be noted that the calculation uses PV (as opposed to NPV) and that a higher Profitability Index does not necessarily mean that an investment offers a higher NPV.

    22. Payback Period is a measure of the amount of time required to pay back the entire investment. In DealSense Plus+, Payback is expressed as the number of years (and fractions thereof) it takes for the cumulative PV of cash flows to equal the investment. Payback of Invested Equity is measured with FCF-E and Payback of Total Invested Capital is measured with FCF-TIC.

When taken together, all of the steps in the DealSense Plus+ Pricing Section makes it easier to test the viability of a given purchase price and structure using the seller’s Pre-Acquisition Projections. Once a price and structure have been determined, the more disciplined, and detailed Post-Acquisition Projections provide a test of the economic viability of the acquisition as planned.

The last section of DealSense Plus+ addresses Return of Investment based upon the buyer’s Post-Acquisition Projections. In this section, the buyer has an opportunity to revise the Hurdle Rate based upon an updated and more finely tuned Cost of Funds. At that point, the program takes the information form the Post-Acquisition Projections and presents, among other things, the Free Cash Flow to Equity, Free Cash Flow to Total Invested Capital, Present Value, Net Present Value, the Hurdle Rate and IRR Spread, Profitability Index and Payback Period.

The buyer who follows the disciplines embedded within DealSense Plus+ will have carefully and thoughtfully arrived at a Purchase Price that avoids the overpayment trap and makes economic sense for the company and its shareholders.

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