The COVID-19 crisis has affected most sectors, including the M&A. Several entrepreneurs are asking how the value of their company has changed because of the crisis. To answer this question, we have to separate those firms that have the financial capacity to survive this crisis and those who don’t. The buyers are also aware of the fact that the crisis has affected all companies and they know that there might be delays in production or difficulties to sell or receive payments. Therefore, the investors do not consider the happenings of 2020 as a base for the value of the business. Currently, the value is determined more subjectively than objectively to facilitate selling the company for a fair price.
Importance of valuation dates First of all, the valuation date has become more important than ever before. As the crisis is has affected the market and the situation of many companies negatively, the value of most companies was not the same in 2019 December, as in 2020 March, and probably it will not be the same in 2021.
Therefore, when determining the value of the business, advisers consider the value before the crisis, and the possible value after the crisis. They treat 2020 as an exception because of the unusual circumstances, as the change in value was not the fault of the business owners, there is no need to punish them.
Price is not equal to value It is also essential to highlight that the value and the worth of a company are not the same. The price is the exact value of the materialization of a company at the moment of the sale and depends on the offer and the demand as well. On the other hand, the value is the monetary measure of the degree of utility that the company reports to it.
Therefore, just because the current value of the company is much lower now than a year ago, does not mean that the price of sale is reduced as well. The important is to find several buyers making offers and competing for the firm, so the company can choose the best option, maximizing the value of the sale.
Risk and Profitability Buyers make their finical decision about the company they want to buy based on the risk and the profitability of the firms. If two companies are facing the same risks, they will choose the one with higher profitability. Some of the risks that buyers have to face because of this extraordinary situation are the regulatory changes or the loss of significant contracts. Nevertheless, these risks will disappear during the year of 2021.
It is also important to mention the risks associated with the cash-flows. We cannot talk about “risk-free” rate anymore, and the unsystematic risk has to include the extra risks because of the COVID-19. Besides, advisers have to rely on the middle and long projections, which might become true, or might not. The recovery of the sector from the crisis should be considered during the valuation, as it may vary by business areas. Also, it is recommended to calculate with the possible change in consumer habits because of the crisis, as it can affect the future profitability of the companies too.
The advisors should make analysis of the expectations of the future situation of the economy and the sector, using the most information at the moment of the valuation, with a goal of providing realistic image of the company. If you want to know how risk affects investment terms, read about it in our article.
Personal Reasons for selling a company Last but not least, the personal reasons can affect the valuation process during the COVID-19 crisis as well. The decision of selling a company evokes emotions in every entrepreneur. If the sale is forced by the external environment, which can be the crisis, an illness or other reasons, it can be even more difficult to finally decide to sell the firm. The business valuation always depends on the personal reasons of the entrepreneur. The seller might want to fasten the process because of personal issues, but it can also occur that he has unrealistic expectations which make the procedure slower. The valuation is an instrument of negotiation, and the negotiation is a dance between the rational arguments, aiming for the best possible result.
To conclude, just because we are in a crisis now, it does not mean that it cannot be the perfect moment for selling your company. It is true, that the COVID-19 crisis has affected the business valuation and the sales process of businesses as well. However, as in every other area of life, we have to adapt to the new situation instead of letting it control us. The buyers and investors are also aware of the extraordinary situation and the M&A advisors continue searching for the best buyer for the firms and they do their best to determine the most appropriate price for both parties.
ONEtoONE Company Valuation Service Having an accurate and comprehensive company valuation is very useful as it provides detailed information on the variables that underpin a business’s value. Company valuation is needed for buyers and sellers to during the sale process. For sellers, valuation is a negotiating tool that assists in the negotiation process. On the other hand, buyers should not accept the seller’s valuation, they should do their own. Our experienced advisors can help you to determine the value of your business, or the business you are planning to buy, to gain a competitive position in the market.
About ONEtoONE At ONEtoONE we have a broad knowledge of the Mergers and Acquisitions sector, as we have participated in more than 1000 mandates. Our company is specialized in international middle-market M&A advisory. We are continuously focusing on improving the techniques to achieve the best possible price for our clients, and we also advise on acquisitions, strategic planning and valuation. We are pleased to give our opinion about company valuation or other aspects of a possible corporate operation. If you need an advisor while buying or selling a company, contact us.
Francisco Duato, Partner of ONEtoONE, interviewed for Capital & Corporate, tells what are the changes that are going to occur in the M&A sector due to the pandemic, mentioning the most affected sectors, as well as the main opportunities for investors.
The COVID-19 crisis has forced many companies to adapt to the new situation. According to Francisco, the ability for innovation and digitization make it visible which sectors can continue to be interesting for investors and which ones cannot. Although the impact of COVID-19 on the M&A sector cannot be evaluated yet, operations show falls in the price of assets, according to current data.
The impact of the crisis on valuations:
Duato first indicates that, as a consequence of the pandemic, non-essential and essential activities suffered drops that have never been seen before, negatively influencing the companies’ valuation. Besides, the advisers still do not have visibility of the evolution of prices and valuations, since all this will depend on the effect of the second wave that is beginning now and will extend into autumn.
“The entrepreneur has to do his best to preserve the value of his Company, and M&A advisors have to sharpen the imagination to transfer most of the value to the transaction price,” explains the ONEtoONE’s Partner.
The advisors’ goal is to find a reasonable and satisfactory price for the seller and the buyer as well, and in this situation after the first wave of Coronavirus, this price may vary. However, if a company’s fundamentals were good before the pandemic, and they remain so in the new scenario, this should not penalize the valuation and the company’s price.
Change in deals in the M&A sector due to the pandemic
Duato comments that depending on the sector operations will fall, and others will be redefined. In affected sectors we are going to see many mergers of companies with high operating leverage.
In our Partner’s opinion, the most difficult part of the consultants’ job today is quantifying the impact of the pandemic on the different companies. As a solution, we have to focus on the strategic sense of operations rather than finances. The strategic decisions taken from now on will affect how the company gets out of this complicated situation.
Also, if we focus on making decisions about deals that had already started before the first wave of Coronavirus, it is a legal challenge. On the one hand, buyers protect themselves with Material Adverse Change (MAC) clauses, and on the other hand, sellers want to maintain the same price before the crisis.
The new situation has changed the decision-making process of investors, Duato adds. Now, when looking for opportunities, it is essential to know which sectors are of interest in this new scenario. Furthermore, not only must we take into account in which sector the company operates, but also to whom it sells.
Which sectors will see their valuations most affected?
According to Francisco, during the pandemic, large technology companies such as Amazon, Google, Apple, and Facebook have achieved outstanding results. Technology has allowed the digitization of companies and users, which has been fundamental in this crisis.
“Technology companies that know how to do well in cybersecurity, cloud services, artificial intelligence, collaborative software, internet, health or e-commerce, among others, will be clear winners, ” Duato says.
However, the tourism sector was the clear loser in this pandemic. Despite this, companies in this sector have a high potential for recovery, and because of this, experts advise keeping these assets.
“The Covid-19, among other effects, has drained the liquidity of companies. In the first instance, the CFOs have focused on preserving the cash by resorting it to officially supported financing lines, but those that have survived this first challenge are facing a new one: solvency management. “, Explains Francisco
Liquidity is the ability to meet short-term payments and is related to the proper management of cash flows. However, solvency is the ability to meet long-term payments and is related to the management of the financial structure of the company.
“The approaches tend to vary greatly depending on the size of the companies. Large companies tend to know and handle the different alternatives well. However, the Spanish SME has traditionally been financed via equity, retention of profits, and bank debt. This is an ideal moment to reopen the debate on the advisability of diversifying the sources of financing and evaluating the options available in the market based on the specific characteristics of each company. It is time to overcome the fears of opening the shareholding to investors such as private equity, which in addition to financing, provides professionalization and support in management,” reflects Francisco.
On the other hand, our Partner comments on his opinion on the role of M&A in current and future times: “As we know, seeing changes in M&A takes time and is not usually the best option when immediate problems have to be solved.” However, he indicates, “not making all these reflections on time can lead companies to situations in which the only option is to turn to opportunistic investors. With this comment I do not want to discredit the work of the funds with a distress profile, they are a good option when we are facing a special or very deteriorated situation, but avoiding reaching that point and trying to maneuver in time is a shared responsibility of the entire management team.”
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The last step of an M&A process is known as the sale and purchase agreement or SPA. It’s time to finalize the agreement and sale price of the firm once a buyer has completed the entire due diligence process and evaluated the company’s actual condition for sale. In order to include all of the terms and circumstances of the transaction, this document will be codified into a public deed and finally presented before a notary.
The buyer is often in charge of creating the initial SPA contract and their legal counsel. There are, however, some exceptions, such as how auctions operate. The participants are given a draft in this situation and will finally return it with their changes and offers.
When creating the contract of sale, excellent care and attention must be taken. A single paragraph in the contract can make the difference between a successful or failing deal. The optimum situation at this point is to get guidance from knowledgeable counsel. one has a track record of success in structuring contracts for business acquisitions. In light of this, the SPA is not a straightforward contract. In actuality, it is complicated.
Find out more about the documentation required during a sale here.
In light of this, the contract of sale is not a straightforward document; instead, it is incredibly intricate. The most common query is: What information should be in the contract? A variety of assets and obligations, connections, current contracts, etc. are all integrated into the document. As a result, the sheer volume of pages in the first version of the document overwhelms many business owners. The critical components of the contract for a business sale are covered in this article.
What is contained in the company SPA?
1. Description of the transaction
This phase describes the transaction, such as the sale of assets or a business. It is crucial to clearly and concisely express each person’s true intentions by utilizing straightforward language.
When selling assets, it is important to be very specific about the pertinent assets that are included in the transaction and the liabilities that are transferred. It will also be specified whether any property that the seller regularly uses, like a car, a parking space, or even their home, is excluded from the sale.
If the transaction involves the sale of stocks and shares rather than assets, a section describing the specific items being sold is included (for example all the stock or only a specific number of shares). When numerous firms and shares of those companies are involved, the boundaries of the transaction are further defined in great detail.
2. Terms of the sale and purchase agreement
The price is the first significant area that is mentioned in the document, along with the conditions that go with it. These conditions include payment methods, forecasts of deferred payments, variable payments based on the achievement of goals, the payment currency, and events that will result in price adjustments (since the final price will be based on the balance at the closing date of the agreement).
Although it is not necessary for this specific transaction, the contract additionally specifies whether the surplus cash is included in the deal or given to the seller as dividends.
3. Representations and warranties of the sale and purchase agreement
On the one hand, the seller promises that the circumstances of the business as described are true and correct. The following are some of the events that the seller must vouch for:
The company is owned by the undersigned and they have the power to make the sale and enter into the contract.
They do not violate any law or other previous contracts.
The company has such a number of shares.
Copies of the articles of association have been delivered to the buyer.
The financial statements are correct.
The company has not undergone any substantial change in its operations since the due diligence.
All tax payments are up to date and correct.
You own the patents and trademarks.
There are no outstanding lawsuits against the company.
No hidden liabilities.
The damage, inconvenience, or loss caused by faulty, false, or untruthful information may be made up to the company’s buyer. This is taken into account while creating liability warranty conditions.
For the retention of a portion of the purchase price or the deposit of that portion, a bank account known as an escrow account is often formed as well. In other circumstances, a simple bank guarantee is accepted.
On the other hand, the company’s contingencies that are already included in the price are described so that (once the buyer knows these contingencies before paying the price) the seller is exonerated with respect to the damages or claims that these contingencies may cause to the buyer. In many cases, a price is put on these contingencies.
When the operation is based on the pre-closing balance sheet, and the data will be adjusted after closing, the representations and warranties will most likely cover the interim period between the two balance sheets.
Be mindful of the following:
Any other associations, relationships, or beneficiaries between the sale subject and third parties.
Any disputes or claims by third parties.
Any loans or credit on the subject of sale.
If a warranty is of particular importance, it may also be necessary to ask all other shareholders to make it explicitly.
Any conflict of interest.
A breach of statements made in this section will result in a breach of contract and liability for the party at fault.
4. Limitations on Responsibility
Usually, the seller’s liability for obligations to the Treasury, Social Security, or third parties is restricted. There are deadlines for filing responsibility claims, except for circumstances involving taxes, employment, social security, or administrative contingencies, where the deadlines correspond with the legal deadlines.
To prevent any minor disputes, the contract typically establishes a minimum level of responsibility over which the seller’s accountability can be discussed. The sum for each transaction will depend on its magnitude and be determined by how comfortable the parties are with the agreement’s structure.
5. Conditions of the sale and purchase agreement
Non-compete clauses are one of the terms of the sale and purchase contract. These provisions are meant to stop the seller from starting a competing business and stealing your clients. It assists in safeguarding the reputation of the business.
Sometimes, a contract of sale is made with the understanding that certain conditions must be completed before closing, such as acquiring approvals, contract assignments, or the seller performing specific tasks beforehand (the sale of a plot of land or its appropriate legalisation in the corresponding register).
The contract’s annexes are a section with a legal significance. Due diligence, financial statements, patents, and certificates of compliance with the Treasury and the Social Security Administration are some of them.
ONEtoONE Sell-side services
Selling a company can be a frustrating and long process. The experience advisors of ONEtoONE could guide and support you during the whole sale procedure, making the maximum value out of the firm and finding the buyer that can pay the most, wherever they are. Find out more about our sell-side services.
If you are considering selling your company prior to the purchase contract, you will have to go through different stages that will help you maximize the final price. These steps can be decisive for the future of the company. If you need the guidance of a reliable team during the process, do not hesitate to contact us.
A formal agreement on the principal components of the sale is normally required for both parties in a buying or selling transaction. This is referred to as a binding offer or letter of intent in m&a deals. This offer formally guarantees that your counterpart’s intention is the same as yours.
If your interested in the binding offer why not find out more about the SPA agreement here?
When someone is planning on buying a company, they need as much information as possible. The buyer will hire experts to make a complete review of the company by checking books and documentation before signing the contract. This will mean a significant expense for the buyer and the supply of information from the seller. Therefore, a formal agreement helps to avoid misunderstandings. This letter of intent states the commitment to begin negotiation of the pending aspects of the agreement that will end in a final sales agreement.
“ This letter of intent states the commitment to begin negotiation of the pending aspects of the agreement that will end in a final sales agreement.
The letter lays down the groundwork for the negotiation and establishes a baseline figure for the price. The points that need to be discussed in order to reach an agreement are highlighted, and time limits for completing negotiations are established.
Find out more about the documentation required during the sale or purchase of a company here.
Why is the offer binding?
The reason that this offer is binding is because both buyer and seller want to make sure that they are negotiating seriously, as one side is going to provide very sensitive information and give exclusivity, and the other side is going to invest resources in advisors. Additionally, a letter of intent is often required to get financing from the bank for the transaction.
When negotiating with a private equity firm, it is highly recommended to establish the letter of intent as binding and closed as possible. It is needed to take all the areas of the operation into consideration, in order to prevent any possible maneuvers of private equity firm after the due diligence is finished.
The complex buying or selling process involves many little tricks, especially with regard to the financial and negotiating sides. Normally, on your first time leading an M&A transaction, you are inexperienced, which is quite a problem as the stakes are high. Due to this reason, we recommend that you surround yourself with well-prepared advisors. In this case, the experience is undoubtedly vital.
If you are looking to optimize the value of your investment within an operation, I encourage you to evaluate ONEtoONE Corporate Finance: a firm dedicated to provide the highest value services to their clients through transparency and professionalism. For more information click the button below.
Are you thinking of buying or selling a company? In the world of mergers and acquisitions, valuation process plays a fundamental role in determining the best estimate value for a business given all its counterparts. There are numerous advantages in understanding the intricacies of the valuation process that will be covered in this article, with the most obvious and prominent benefit being the understanding of the intrinsic value of a business – a vital milestone for its further sale.
It is essential to differentiate the value of a company from its price. The price is the specific value of a company materialized at the moment of the sale, depending on the supply and demand of the market at that moment. A value of a company is what every potential buyer gives a company depending on his profile and interests. It is the monetary measure of how useful the company is going to be for that person.
Numerous business owners and entrepreneurs underestimate or simply are unaware of what the business valuation process entails and where it begins. This is a common scenario as the valuation process is a complex multistep process with different methods of approach. Independent of the valuation method you choose, valuating a company is a process where current value generating elements of the company are measured, as well as its competitive position within its sector and its future financial expectations. The type of valuation method used for analysis will then depend on factors such as the industry sector where the company operates, the size of the company, expected cash flow and the type of product or service it offers. For example, it is generally not advised to use the valuation method of comparable transactions if the sales volume or profits are 50% lower than that of the target company.
The valuation process is intrinsically technical, hence it is vitally important that whoever is conducting the valuation acquires financial knowledge. The valuator should also be aware of the company’s business model, its strategy, have a thorough understanding of the market where it operates, and the value-creating elements it acquires.
“The main objective of the business valuation is to identify the key value-generating areas of the business.
The main objective of the valuation process is to identify the critical value-generating areas of the business. It is essential to consider which areas of your business may be of specific interest or value to the counterpart of the deal, as this will mostly determine the valuation results. For example, depending on the mindset and objectives of the investor, their interest may not be as much the profitability of the business, but perhaps the market share, strategic positioning, or a specialized area of the company’s value chain. The valuation result is then considered a significant estimation of a value range that will be a pivotal point in the negotiation of the final price paid for the deal. The valuation results are, therefore, important not only for identifying the key profit drivers of the business, but also setting a pinpoint for upcoming deal negotiations.
Factors to Consider
Before beginning the business valuation process, certain key factors must be taken into consideration. These include:
1. Profitability and risk. Substantially all of the considerations made during the valuation fall into two categories: profitability and risk. This is because an investor looks at the opportunity cost of making the deal, so if there is a deal that is as profitable but induces less risk, it is more likely to be an investment option.
2. Personal reasons. Investors are people too! Emotions or non-economic factors may influence the decision-making process and hence the valuation process results. For example, if a seller is motivated to sell his business as fast as possible, the factor of time will be of priority over selling at fair value due to any personal or emotional reason that may be the case. It is, therefore, vital to understand what the bottom line reasoning for the deal is for both counterparts of the transaction.
3. Company surroundings affect value. Companies are not islands. Their value depends on external factors and market forces. For example, if the stock market trades at multiple high volumes, your company will be worth more independent of its intrinsic value. Comparing to the value of the same company when the stock market is cool, even if your company is private and will remain to be so. This is because the stock market is an investment alternative for any investor. For example, if you are a construction company willing to invest, and you are offered a small-sized business industry for twice the value of the investment that could have been invested in a comparably larger sized firm’s shares on the stock market, the latter would have been the safest option for an investor. A company would have to have significant strategic value or potential for a buyer to consider it over the latter investment
4. Proper valuation requires valid information. Before considering performing a valuation and making future value predictions, the company’s past and present data must be accurate and correct. Only with this kind of data, and together with a strategic approach, a reliable estimation and valuable conclusions can be made. The more comprehensive and detailed the information you acquire about the business model, operations, and finances of the business before beginning the valuation, the better quality and precision the results will have.
Types of business valuations
There are several methods of valuation used, depending on the objective of the assessment. However, the two most prominent methods used by analysts are the discount free cash flows method and the comparable transactions method:
1.Discounted Free Cash Flow method (DCF).
This method aims to determine the company’s ability to generate wealth, estimating the money that the owners could take home with them during the company’s lifespan. This method is used to convert these future cash flows into today’s currency, using a “discount rate” to reflect future money’s value discounted to today’s value, including the potential risk associated with the said generation of wealth. Essentially, this method provides insight into the future performance of the company and its ability to generate cash flow via the company’s resources.
The Discounted Free Cash Flow method requires analysis of the past, historical data. This will provide an insight into which factors lead to incurred costs and which generated revenues. Particular attention should also be paid to the factors that might affect future financial projections. The function should include revenues, costs, profits, investment plans, projected cash flow, and the economic structure of the company. This projection will act as a hypothesis about future financial data (balances, income statements, etc.).
Also, market analysis and competitive positioning analysis must be taken into consideration when this valuation method is performed. Understanding the effects of the Porter´s five forces (barriers to entry, threat of substitutes, negotiation power of buyer, negotiation power of the supplier and rivalry among competitors) will allow us to anticipate an increase in demand, measure the negotiating power of clients and suppliers, and understand the company’s vulnerability with respect to substitute products or the degree of price competitiveness within the sector. Furthermore, the analysis of your competitive positioning concerning the competitors operating in the same industry sector will increase or decrease the final value of the deal.
After these preliminary analyses are covered, the cash flow can be estimated – this will be an estimate of the future cash that a shareholder can take home without damaging the growth of the company, consequently for some time. This time is usually a range from 4-5 years. After that, estimating an accurate value can be extremely complicated. For this reason, buyers often calculate projections for a shorter time than sellers. Remember that the future cash flows must be discounted to a discount rate because the value of money today is not the same as it will be in the future.
2.Comparable transactions method.
This method proposes a set of unique advantages. It’s faster, simpler, and more practical, although it may prove to be far from reality if conducted incorrectly. Because the analysis of this method is based on assumptions, it can potentially lead to future discrepancies between the seller and the buyer. This is due to the sellers often basing their price on the next value generation (or what the buyer will do with the company), which can lead to issues occurring during the breakdown of negotiations, as both parties have different expectations. For this reason, the discount cash flow method of valuation can prove to be more accurate.
It is highly advised not to compare companies based on sales volume, or profits lower than 50% of the target company, as the compared multiples become insignificant due to the vast difference between the company sizes. It’s also critically important to have a comprehensive database of past mergers and acquisitions and a thorough knowledge of the targeted sector along with all its participants. In practice, most buyers choose the simplified valuation method based on EBITDA multiples. Valuating by multiples is a valid method only if the following criteria are reached: If you have a wide range of similar companies If the scope of companies or transactions is homogeneous If the data is relevant and timely
Using the multiples can help you understand how much is being paid for companies like yours and can prove to be most useful during negotiations, especially if you have information about the history of transactions of the counterpart. A best practice would assume the application of both methods in complement to each other to ensure a higher precision of the estimated value.
Ultimately, the valuation process is a preliminary task to sell your company. It provides insight into the critical areas of a business, allowing owners to leverage the advantages and focus on improving vulnerabilities. Most importantly, this valuation provides an accurate estimation of the value range that both counterparts of the deal can use as the backbone of the deal negotiations. As discussed earlier, there is no ultimate formula or perfect valuation method for each situation. Still, by knowing the characteristics of the company and its corresponding environment, the best fit method can be chosen from a variety. It is an essential process to be able to maximize the price of the company backed by logical reasoning and numerical arguments.
“The business valuation is an essential process to be able to maximize the price of the company backed by logical reasoning and numerical arguments.
Secondly, the valuation results act as a solid pivotal cornerstone of negotiations and don’t bind to the final price of the deal. It is a rarity to see both buyers and sellers agree on the set price immediately, so the valuation, in a sense, brings the two sides of expectations to a middle ground.
Thirdly, valid and comprehensive data is what makes a proper valuation. Therefore, before addressing any of the valuation methods, it is critically important to validate that the historical financial data available to the company is coherent and accurate. Only with valid data and a well-planned strategic approach can a reliable projection be made. Furthermore, the more complete and detailed the available information is, the more accurate and higher quality the valuation results will become.
We have learned that the most common valuation methods are the so-called discount free cash flow method and the comparable transactions method. The discount free cash flow method acquires its main advantage in its capacity to measure future results today. It is a more tedious and complex method, so the majority of investors and business owners, especially in the early stages, prefer to use the simpler alternative called comparable transactions method. Even though this method is simpler, it poses a set of research requirements, such as having access to a large enough database with past mergers and acquisitions, and preliminary knowledge of the industry sector.
Lastly, despite having several business valuation formulas, the key to the analysis resides in the team in charge of the operation. The company acting as an advisor of the deal must take into account future factors such as the projection of the company, the possibility of alliances with other companies, investment in R&D, changes in regulations, possible shifts in consumer habits, the internationalization of the company or the possibility of adapting the product or service to foreign markets, the possibility of exploiting new product ranges, and so on.
If you still have any doubts about business valuation, now you can download ONEtoONE´s new free eBook “HOW TO VALUE A COMPANY? THREE MAIN BUSINESS VALUATION METHODS”. You will learn how to develop the most common methods used in the market and the key concepts that revolve around the business valuation process. Additionally, if you require any professional advice, do not hesitate to contact our team.
It is time to materialize all the work you have done for an entire lifetime. How can you prove that is the right moment? The most important instrument to figure out this doubt is the company valuation.
Before explaining the reason why the valuation of a company is necessary inside a M&A process, it is important that you understand what it means. A company valuation, regardless the method you choose, is a process where the actual elements of the company are measured, as well as its competitive position within its sector and its future financial expectations.
Through this analysis, the elements that create value will be determined and it will be possible to specify a value range for the company. The value range will be an informed opinion of what the company in question could be worth.
Company valuation is a technical work. In order to value a company properly, an extensive financial knowledge is required. Simultaneously, you should first know in depth the company’s business model, the corporate strategy, and the market where they play in. And last, but not least, the factors that create value to the company. Looking beyond the traditional numerical due diligence parameters allows buyers to best calculate the true value of a company to them and sellers to justify a higher asking price.
A company valuation is not an auditory, the analyst doesn’t question the given finances; nor is it an exhaustive diagnostic of all the company’s areas. From the beginning, the valuator will focus on critical areas that will show where the company’s value lies.
The above sentence holds a very deep meaning. For the owner, very often the founder of a company, who has dedicated his entire life to it, his company is ‘like a son’ and he generally has exaggerated expectations about its value. Because of this, I recommend that if you are the seller, you should put yourself in the shoes of the buyer; the buyer will see things in a different way and his first thought will be: “If I pay all of this for a company, how am I going to earn money?”
A Strict Company Valuation Gives You Elements to Raise a Good Negotiation
It is very important to understand that the company valuation is an uncertain science, but if you want to sell your company it is essential to make a careful and strict valuation that gives you elements to raise a good negotiation with your potential buyers. Don’t get comfortable because the buyers will make their valuation too, so they can see how much money they are willing to pay for the company.
The final goal of a valuation is going to condition the methods you will prefer to use. The valuation method used will change depending on the recipient. The buyer is always going to use a method to demonstrate that the value of your company is lower, and the seller will use the method that shows that the value is higher.
When you value to negotiate this kind of transaction, any method is valid, as long as it sustains a rational negotiation. It is essential to value your company because it is your principal tool for the sale of your company.
If you consider the sale of your company, as well as correctly valuing your business, you will have to go through different stages to help you maximize the final price. Do you know which ones they are? Download the eBook “HOW TO MAXIMIZE THE PRICE OF YOUR COMPANY” where, in a simple way, we explain how to prepare the company for sale.
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.
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. 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!
Sometimes, when we indicate a company’s value range to the owner, he says to us: “for me it’s worth more”. But what is the real value of your business?
The above sentence holds a very valid point: for a business’ founder, who has dedicated his life to it, the company is like a child and he generally has inflated expectations about its value. Because of this, we recommend that if you are the seller, you need to put yourself in the shoes of the buyer. The buyer will see things in a different way and will think: “If I pay all of this for a company, how am I going to earn money?”
For many business owners their company´s value is the result of the addition of three types of value: Intrinsic value+market value+emotional value. Let´s analyze the three components:
External valuations serve to help understand a company’s intrinsic value range and often act as a negotiation tool to reach a higher range. Note that we say ‘value range’ because, although it is possible to estimate how much a company is worth, it is absurd to think that you can estimate the exact amount because it doesn’t exist. Valuation professionals always speak of value ranges.
The buyer will try to acquire the target company for its intrinsic value in that moment, according to how it is being managed, and it will be the buyer who increases its value by improving management.
Try to analyze, when negotiation with potential buyers, not only the value of the company you’re selling, but all the elements that cause an increase in value for the purchasing party.
If you find the right buyer, you might add the market value to the intrinsic value.
A buyer might reinforce his competitive strengths by creating synergies with the acquired company. Synergies let you obtain bigger margins when you are merged. Two plus two can be five.
Once you know the buyer, it is also very useful to calculate synergies, and through these calculations, know how much the company is worth for him. If we are able to negotiate well, it will let us capture a lot of the value of the synergies we find.
Here comes the emotional value: we once had a buy-side mandate and the seller told us that the price for his company was six million dollars. When asked why, he told us that he had six daughters. We explained to him that we would have looked for another seller with a similar company and less daughters. It didn’t seem right to us that he would have made our client pay for his fertility.
The true value
Companies are valued based on their “profitability” and their “risk”. All the other elements end up fitting into these two concepts. If the buyer has another alternative where he can get more profit with the same risk, he will take it.
Seek a buyer with considerable liquidity for whom your company offers these synergies, without regard to where they are located. If this potential buyer perceives real value, he will pay more money for your company.
In our experience, price is usually a result of the quality of the sales process. Good preparation, well presented, clear documents, access to a good selection of candidates, proper management of confidentiality during the process and a proper negotiation of offers will maximize the price and other terms of the transaction.
The more offers a company receives the greater is the probability to find the best buyer, because more offers means greater bargaining power. Experience has shown us that a well-managed well-worked sales process has a tremendous impact on the final price and conditions of a transaction.
By selling your company you are converting years of work and effort into value and, in a short space of time, you can potentially create or destroy a lot of its value. It is in your hands.
Many private investment transactions do not close due to issues about how future business risks are allocated between the parties. Investors often want to take as little risk as possible, which leads to them offering lower entry company valuation. Company owners, on the other hand, often reject low company valuation on the ground that they do not capture the company’s future growth potential.
Rather than let these often opposing perspectives derail investment transactions, creative deal structuring can allow future business risk to be shared between the parties in a way that allows deals to get done and company valuation based on forward-looking risk analyses to be replaced with actual business performance.
How Does Risk Affect Investment Terms?
Investment risk has a major impact on investment terms. In many types of investments in companies, investment terms are based on company valuations. Company valuations, in turn, are often determined based on a company’s future cash flows, which are discounted back to the present through a consideration of the perceived risks related to those cash flows. The higher the risk is perceived to be, the lower the company valuation. This is a major problem in investment negotiations, because apart from the natural economic inclination of parties to approach valuation in a way that favors their own interests, valuation is significantly complicated by the fact that no one can predict the future. This unavoidable inability leads to investors as well as company owners trying to convert the unknown future into an often rigid valuation formula, a process which in pure financial terms almost invariably works to the detriment of one of the parties.
While one might take the view that investment terms upside or downside that results from inefficiencies in valuation is an unavoidable part of the investment process, the reality is that, rather than causing one party to leave money on the table, these uncertainties often lead to investment transactions not closing. This is a problem that has significant negative implications, not only for companies and investors, but also the capital distribution infrastructure that lies at the base of every economy.
An alternative to the zero-sum approach to risk allocation in discussing deal conditions is to design investment terms around formulas that allow risk to be shared rather than unilaterally assumed by one of the parties.
One common risk sharing formula is an earn-out. With an earn-out, a portion of the deal consideration price is deferred to the future and paid upon the company reaching certain agreed milestones, such as with respect to sales, EBITDA or net income. With this type of approach, the seller can effectively receive a much higher entry valuation based on strong company growth if the company can actually achieve that growth. If it can’t, the investor will not overpay for forecasted business performance that never occurred.
In addition to the earn-out, another approach that can be used is bonus or incentive payments that reward management in the event that agreed financial or operational thresholds are met. These types of formulas can allow the economic benefits of higher valuations to be replicated without putting in place complicated post-closing terms and conditions that can create legal and practical issues down the road.
Issues to Keep in Mind
Risk-sharing formulas such as earn-outs can be powerful tools to help bridge valuation disagreements in private investment transactions but there are issues to keep in mind to make sure that these formulas solve valuation challenges rather than create new ones.
Simplicity. The first issue is to make sure that the risk-sharing formulas that are used are simple, clear and easy to apply. The more complex that risk-sharing formulas are, the greater the risk that they will lead to disputes in the future.
Control. The second issue is level of control of the parties over risk-sharing formula drivers. If formulas are based on results that can be manipulated through operational or accounting techniques, the benefits of risk-sharing formulas can easily be lost.
Timing. A third issue to keep in mind is the timing of the implementation of risk-sharing formulas. Future risk is of course not fixed, and as the business moves forward in time the risks its faces will change, rise and fall. Accordingly, the further out in time a risk-sharing formula is structured, the greater the likelihood its utility as a mechanism to apportion risk and the economic benefits related to future business performance will fall.
While they need to be applied with care, risk sharing formulas can be helpful ways to bridge valuation disagreements in private investment transactions and increase the likelihood, not only that deals get done, but that get done on terms that are fair for all parties.
If you miss this wave you will be devoured as the fate of individual companies has never been more uncertain, and the window of opportunity is closing for many companies unprepared or unable to adapt to the new market realities.
There are five reasons why you should ride the current M&A wave:
1. Companies are valued by estimating their future profits. When a company is in a very profitable stage, a promising future can be projected, which will maximize its price. When it´s going through a bad phase it´s much more difficult to make an exciting future credible.
2. The economy has cycles. The key is to sell during a buoyant economic cycle, not only because the company has a higher turnover and makes a better profit during this phase, but also because buyers are more optimistic and there´s a greater abundance of money.
3. In buoyant periods, companies listed on the stock market are willing to pay more because their shares also lists at higher multiples. In economic booms, it´s also easier for buyers to obtain financing for purchases, either through banks or by issuing corporate debt, which allows them to pay even more for your business.
4. Another external element which affects your company´s value is interest rates. When rates are high, companies are worth less and when they´re low, companies are worth more.
This is because value is estimated by discounting the cash flow that the company will generate during the rest of its existence. It´s discounted based on interest rates plus a prime that represents the risk of the company not meeting its expectations. If interest rates are low, it´s discounted at a lower rate. Due to the denominator being lower, the resulting figure in the valuation is higher. This is why companies are worth more at lower interest rates than at higher ones.
5. Today money is abundant, the value of companies in the stock market have never been higher, interest rates worldwide are at the lowest level ever seen, and there is a huge M&A wave. Ride the wave before it goes.
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