M&A Viewpoint: The Value, Price and Cost of Acquisitions

(Part 1 of 3)

What is the difference between the value, price and cost of an acquisition and why should you care? After all, the terms are often used interchangeably. It's not uncommon to hear business buyers say: "The seller accepted our valuation of $25 Million." "We paid the seller's price of $25 Million." "That deal cost us $25 Million."

Each expression leaves you with the general impression that the buyer shelled-out somewhere in the neighborhood of $25 Million for the company. While this might suffice for pedestrian conversation, M&A analysis and planning requires a deeper understanding of each term and its significance to the dealmaking process.

An asset's value is different from what you're willing to pay for it, and the price you're willing to pay is different from the total cost of obtaining control of the asset. Each word has its own distinct meaning. When we talk about value in the M&A context, we are really talking about Fair Market Value (FMV).

Just what is Fair Market Value?

The classic definition of FMV is the price, in terms of cash or equivalent, that a buyer could reasonably be expected to pay, and a seller could reasonably be expected to accept, if the business were exposed for sale on the open market for a reasonable period of time, with both buyer and seller being in possession of the pertinent facts and neither being under any compulsion to act.

When it comes to valuing privately held businesses, there is no "Blue Book" or other so-called definitive source to consult. Each business is unique from every other one. If you want to know the value of a privately held business, you are going to need a valuation.

You'd think it would be easy to determine the value of a publicly traded company, right? Just find out the price-per-share at the close of a given day and multiply it by the number of shares outstanding. Sorry. The quoted trading price of a publicly traded equity security is based on a single share or small block of shares. You still need to consider the principles of valuation and arrive at an appropriate "control premium" before you can zero in on the company's FMV. The single-share price gives you a starting point, but you still need a valuation.

A fair market valuation is an estimate or opinion of the theoretical worth of a company's equity based upon its underlying assets, income generating ability, and comparable transactions. There are accepted procedures, methods and formulae for preparing valuations. These accepted approaches and methods have been tested in tax, legal and other contentious matters. The documentation included with MoneySoft's Corporate Valuation Professional™ software summarizes the three main approaches as follows:

"The Asset Approach is generally considered to yield the minimum benchmark of value for an operating enterprise. The most common methods within this approach are Net Asset Value and Liquidation Value. Net Asset Value represents net equity of the business after assets and liabilities have been adjusted to their fair market values. Liquidation Value represents the present value of the estimated net proceeds from liquidating the Company's assets and paying off its liabilities.

The Income Approach estimates the value of a specific benefit stream with consideration given to the risk inherent in that stream. This approach is based on the fundamental investment principle that the overall value of an investment is equal to the present value of all future benefits that accrue to the investor. The most common methods under this approach are Capitalization of Earnings and Discounted Future Earnings. Under the Capitalization of Earnings method, normalized historic earnings are capitalized at a rate that reflects the risk inherent in the expected future growth in those earnings. The Discounted Future Earnings method discounts projected future earnings back to present value at a rate that reflects the risk inherent in the projected earnings.

The Market Approach compares the subject company to the prices of similar companies operating in the same industry that are either publicly traded or, if privately owned, have been sold recently. A common problem for privately owned businesses is a lack of publicly available comparable data."

The valuation methods and approaches used in Corporate Valuation Professional and DealSense™ were designed in collaboration with Practitioner Publishing Company (a Thomson Company) and conform to their "Guide to Business Valuations", edited by Dr. Shannon Pratt and other highly recognized valuation authorities. You gather the numbers and background information and apply good judgment, and MoneySoft takes care of the math and modeling.

Which valuation approach is appropriate?

Different valuation approaches will frequently yield strikingly different results for a given company. It's the duty of the analyst or valuator to select the approach that is most appropriate given the facts and circumstances of the company. Here are a few examples of how different approaches can produce different values:

• The asset approach might be most appropriate when valuing a mature, capital-intensive company with steady sales and marginal profitability in a competitive industry. On the other hand, if you apply the income approaches to such a company, the resulting value would be a fraction of its underlying assets, less if you deduct the company's debt.The income approach may best suit a company that has a history of earnings but few tangible assets, such as an engineering firm. Now in this case, if you rely on the asset approach, you'll probably get a value that represents pennies on every dollar of cash flow-a good deal if you could get it, but hardly a reasonable valuation.
• The market or comparable approach may favor a younger company with little sales and no significant earnings in a "hot sector" such as a technology company before the "dot.bombs" exploded. Since the company has no assets and no income, just a lot of promise (sounds like a good deal, right?), both the asset and income approach are going to yield low (if any) values.

So which approach is right for valuing a given company? The one that is most appropriate given the industry, financial position and other related acts and circumstances. Nobody said it would be easy! You've got to exercise some discipline, do some digging and apply good judgment. Here again, MoneySoft's software systems can help streamline and automate the process so you can focus on the critical judgment issues necessary for a supportable valuation.

Why is it wise for a buyer to obtain a fair market valuation?

The chances are pretty good that a buyer is going to pay more than FMV for the company. A diligent buyer (as opposed to a negligent one) should know the spread between FMV and the price they are willing to pay. Without a fair market valuation, a buyer has no meaningful benchmark of value other than what they are willing to pay.

The spread between the seller's asking price and the fair market valuation serves as a useful reference point for "reality testing" and determining how deep the buyer is going to have to dig to find synergies (the rationale we use to justify a higher than market price). The spread between price (plus acquisition related costs) and FMV represents a financial risk that the buyer must carry.

If the deal goes south and you have to divest the company, the market value serves as a baseline of what you might expect the company to fetch. Of course, this assumes that there has not been any significant deterioration of value after the closing.

So, maybe you're thinking: "Gee, that's nice, but why should I REALLY worry about FMV?"

Do the letters CYA meaning anything to you? In this case the "A" is your professional reputation and your legal posterior. If a premium over market value is paid and the deal is successful, you're a hero. On the other hand, if the deal turns into a disappointment, you are going to have to clean up the mess. In addition, members of the board of directors or shareholders might start asking uncomfortable questions such as: "What the hell were you thinking by paying that much?" Without a valuation and a reasonable justification for the spread between that value and the purchase price, you might find yourself on the hot seat, or worse.

Should the valuation be prepared internally or by an independent professional?

Our recommendation is to do both. An independent, outside valuation is a prudent step. It can't hurt to carefully consider an outsider's opinion of value. In addition, by preparing your own internal valuation study, you will gain a richer insight into the company and the factors that drive its valuation. The exercise will be good for you. If you've obtained an independent valuation, your internally prepared valuation will provide an intelligent way to bridge any gaps that might exist between your perception of value and the independent one. If you rely totally upon the outside valuation, you might face the questions: "Well, didn't you do anything internally to verify the valuation or did you just accept it on the basis of the valuator's credentials?" I don't know about you, but I would like to do more than hide behind a hired gun's credentials. He might not be that good of a witness. Worse yet, he could be flat wrong. Remember in practically all matters of valuation that are litigated, half of the experts are on a losing team. In some cases both are adjudicated as wrong and the judge issues a "settlement value."

So, assuming that you followed this recommendation, you will have an internal valuation and an outside valuation plus a diligent understanding and reconciliation of the differences between the two. The next step determines the price-what you are willing to pay. We'll cover that in the next M&A Viewpoint.

By Robert B. Machiz
CEO MoneySoft, Inc.
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