The primary objective for most sellers in an M&A deal is to maximize price increasing the firm’s value. While many people assume that valuation in an M&A deal is driven either by the mechanical application of EBITDA multiple valuation techniques or simply by the party who has greater negotiating power, in fact the final sale price of a company often is highly dependent on the buyer’s perception of risk in connection with a company and the seller’s ability to demonstrate the degree to which that risk has been or could be mitigated.
The often significant space between price terms derived from valuation formulas and the deal preferences of the parties is the area where large amounts of potential transaction value can be won or lost. This space, often overlooked in deal preparations and negotiations, is worth a great amount of M&A transaction focus. For shareholders that want to sell companies at the highest price possible, objectively thinking through the risks a company faces and trying to mitigate them before deal negotiations begin is often an excellent way to accelerate deal completion times and improve sale terms and conditions.
The relationship between risk and value
When thinking about how much a firm is worth, many people focus on the current or past financial performance of a company and consider such factors as revenue, EBITDA and net income. However, the risks associated with a firm’s financial performance going forward are also an extremely important component of the firm’s worth.
The relationship between risk and value is expressly incorporated into one valuation approach, the Discounted Cash Flow method of valuation. With this valuation technique, a company’s current value is derived by discounting the company’s future free cash flows back to the present by a discount rate which is directly related to how risky those cash flows are. The higher the discount rate, the lower the present value of the company will be and the less a buyer will generally be willing to pay for it.
Key types of risk that affect firm valuation
Generally the types of risks that can affect a firm’s performance and value can be grouped into three broad categories.
The first category of risk is macroeconomic risk. These are risks that affect a country as a whole such as political stability, GDP growth, inflation rates and currency values.
The second category of risk is microeconomic risk. These are risks that define the specific market that a company operates in, impact the core relationships between market producers and consumers and influence competition.
The third type of risk is company risk. These are specific risks that are related to a company such as its business model, the nature of its revenue streams, the strength and commitment of its management team and its financial and physical resources and infrastructure.
When setting a price for a company, many buyers will begin with a baseline framework for valuation based on an industry and then adjust that baseline valuation based on how risky a company is compared with valuation peer groups.
There is no standard way for converting risk perspectives into company price adjustments. This is inevitably a subjective process based on the buyer’s outlook, experience with a country or sector and ability to mitigate risks after a company has been acquired.
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The relationship between investor return expectations and value
Another way that buyers approach valuation is based on their own transaction investment horizons and return expectations. If an investor expects to purchase a company and sell it in 7 years and receive a return of 15%, it will often set the price for the company at an amount which will make it highly likely that it will achieve that return, even if a fair analysis of the risks related to the company warrant a higher price.
While this method approaches valuation from a different perspective, it ultimately leads to the same risk-based result: the greater the risks to the ability of a buyer to sell a company at a price in the future, the greater the likelihood it will simply lower the price it will pay to ensure that the difference between the current purchase and subsequent company sale price will be enough to cause the buyer’s target investment return to be met.
Reducing downside to increase upside
Regardless of whether the issue of valuation is approached from an objective view of the risks related to a company or the investor’s return expectations, it is clear that the better risks can be forecast and mitigated, the better the valuation is going to be.
Many sellers make the mistake in price negotiations of trying to simply explain risks away with verbal statements rather than backing up risk discussion and mitigation strategies with substantive analysis and concrete corporate actions. Let’s provide a few concrete examples of how risks can be mitigated.
● Macroeconomic risk. While it may seem by definition that macroeconomic risks are beyond the control of a single firm, in fact several types of macroeconomic risks can be mitigated. To provide one example, let’s assume that a firm is highly exposed to currency risk and operates in a country whose currency is highly volatile. To mitigate this risk, a company might, for example, be able to denominate key contracts in dollars or another benchmark currency which would eliminate a significant amount of the impact of currency volatility on its business.
● Microeconomic risk. Given that at its heart microeconomics is concerned with the interplay of producer and consumer relationships, reducing microeconomic risk requires positioning a company to drive or take advantage of potential market shifts. To provide one example, let’s assume that a company operates in the petroleum fuel-based extraction market but is highly susceptible to the loss of market share given the fact that it has less financial resources than its competitors. To mitigate this risk, a company might seek to enter into the renewable energy sector to broaden and diversify its revenue model.
● Company risk. There are many types of company risks which can cause a company’s value to fall, such as a lack of diversified revenues, uncertainty regarding legal issues that may affect the company and uncertainty regarding a firm’s commercial arrangements. If a seller derives a significant amount of revenues from a client who is free to cancel the commercial relationship at any time, a seller might try to negotiate a longer term contract with the client. While this may not fundamentally alter the commercial relationship between the seller and the client, it will often give buyers significant additional confidence regarding the strength of a company’s financial projections. Moreover, even if a seller is required to provide discounted commercial terms to a client in exchange for the client’s execution of a long-term contract, the economic value of this discount may turn out to be less than the positive impact it causes on the firm’s valuation.
● Exit risk. While sellers may take the position that how a buyer will exit an investment 7 years down the road is of sole concern to the buyer, in fact it is also the seller’s concern. Why? Because if the investor does not have the confidence that it will be able to exit, it often will simply not invest and the deal will not go forward. This is particularly true with investors such as investment funds, which often must exit their investment positions within fixed periods of time.
While most business owners understandably dedicate the majority of their focus on how to build their businesses rather than looking for ways to get out of it, developing an understanding of who the potential buyers for a company are and how they are thinking about valuation issues is extremely useful, both while building a company and when it comes time to sell it.
This article written by Darin Bifani, has provided a brief overview of ways that can increase the value of your firm in an M&A transaction by focusing on mitigating key risks that impact firm valuation. Be aware of the the risks affecting your business and how they can be mitigated to help increase your firm’s value today. Learn more about our strategic advisory now!