The primary objective for most sellers in an M&A deal is to maximize price increasing the firm’s value. Many people assume M&A valuation is driven by applying EBITDA multiples or by the party with greater negotiating power. However, the final sale price often depends on the buyer’s perception of the company’s risk. It also depends on the seller’s ability to show how that risk has been or can be mitigated.
The gap between price terms from valuation formulas and the parties’ deal preferences can create or destroy significant transaction value. This gap is often overlooked during deal preparation and negotiations. It deserves careful attention in M&A transactions. Shareholders who want the highest sale price should objectively assess their company’s risks. They should try to mitigate these risks before negotiations begin. Doing so can accelerate deal completion. It can also improve the terms and conditions of the sale.
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. Examples include 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. They 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. Then they 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.
IF YOU ARE INTERESTED IN LEARNING MORE ABOUT FIRM VALUATION, YOU CAN ALSO HAVE A LOOK AT “THE REAL VALUE OF YOUR BUSINESS“, WHERE WE ANALYZE THREE TYPES OF VALUE: INTRINSIC VALUE, MARKET VALUE AND EMOTIONAL VALUE
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
At its core, microeconomics studies the interplay between producers and consumers. Reducing microeconomic risk requires positioning a company to drive or take advantage of potential market shifts. For example, consider a company operating in the petroleum fuel-based extraction market. It is highly susceptible to losing market share because it has fewer financial resources than its competitors. To mitigate this risk, the company might enter the renewable energy sector to broaden and diversify its revenue model.
Company risk
Many types of company risks can reduce a company’s value. Examples include a lack of diversified revenues, uncertainty about legal issues, and unclear commercial arrangements. If a seller earns significant revenue from a client who can cancel at any time, they might try to negotiate a longer-term contract.
While this may not fundamentally change the commercial relationship, it often gives buyers more confidence in the company’s financial projections. Even if the seller must offer discounted terms to secure a long-term contract, the economic cost of the discount may be smaller than the positive impact on the company’s valuation.
Exit risk
Sellers may think a buyer’s exit strategy seven years later is only the buyer’s concern. In fact, it also concerns the seller. If the investor lacks confidence in exiting, they may not invest. Without investment, the deal will fail. This is especially true for investment funds, which often must exit positions within fixed timeframes.
Most business owners understandably focus on building their businesses rather than planning an exit. However, understanding potential buyers is extremely useful. Knowing how buyers think about valuation helps while growing the company. It also helps when it comes time to sell.
This article written by Darin Bifani. Learn more about our strategic advisory now!
