Tag Archives: Company Valuation

The sale and purchase agreement (SPA): what should it contain?

The expected last phase of an M&A process is known as the sale and purchase agreement or SPA. After the entire due diligence procedure, and when a buyer had analyzed the true state of the company for sale, it is finally time to map out the agreement and sale price of the company. Thus, this is the document that will be formalized into a public deed and ultimately presented before a notary, including all of the terms and conditions of the sale.

Most commonly, the buyer, along with their legal advisors, is in charge of preparing the first version of the contract. However, there are exceptions such as the process associated with auctions. In this case, a draft is delivered to the contestants, who will ultimately return the document with their modifications and offers.

A great level of detail and care is required when drafting the contract of sale; a single paragraph in the contract can be the difference between a successful or failed agreement. The ideal scenario at this stage is to have an experienced advisor who has a proven track record in successfully drafting contracts for the sale of companies.

With this in mind, the contract of sale is not a simple document; in fact, it is enormously complex. The most frequent question is: what should be included in the contract? The document integrates an array of assets and liabilities, relationships, existing contracts, etc. In consequence, many entrepreneurs are overwhelmed with the sheer amount of pages contained in the first version of the document. In the article, we are covering the main parts of the contract of a business sale.

What is contained in the company sale agreement?

The contract has five main parts: (1) Description of the transaction; (2) Terms of the agreement; (3) Representations and warranties; (4) Limitations on responsibility; (5) Conditions.

1) Description of the transaction

This stage explains the type of operation, whether it is selling a business or assets. It is very important to describe the real intentions of each one of them, using a direct language, being clear and concise.

In case of a sale of assets, the relevant assets that enter the transaction and the obligations that are transferred should be detailed precisely. Likewise, it will be defined if any property that the seller habitually uses, such as a vehicle, parking space or even their home, is left out of the transaction.

If it is not a sale of assets but a sale of stocks and shares, a section that defines what exactly is being sold is incorporated (for example all the stock or only a specific amount of shares). When there are several companies and shares of companies involved, it is further clarified in detail what is within the perimeter of the transaction.

2) Terms of agreement

The first major area that is indicated in the document is the price, along with its corresponding conditions: payment methods, forecast or not of deferred payments, variable payments based on fulfillment of objectives, currency of payment, and circumstances that will produce adjustments in the price (since the final price will be based on the balance at the closing date of the agreement). The contract also includes the information of whether the surplus cash is part of the transaction or is taken by the seller as dividends, although it is not necessary for this particular transaction.

3) Representations and warranties

On the one hand, the seller guarantees that the described circumstances of the company are accurate and correct. Some of the events that the seller has to corroborate are the following: the company belongs to the signatories and they have the authority to sell the company; the transaction does not violate any law or other previous contracts; the company holds such as the number of shares, the approval that all the financial statements are correct, all tax payments are updated, that  the company has not suffered any substantial change in its performance since the due diligence (distribution of dividends, raised salaries or newly signed contracts that could harm the buyer); copies of the bylaws are delivered to the buyer; and the company patents and trademarks are in place.

In the event of inaccuracy, incorrectness or untruthful information, the buyer of the company can be compensated for the caused damage, a contingency or a loss. For this purpose, liability warranty clauses are established. Besides, retention of part of the price or the deposit of that portion is usually introduced in a bank account called an escrow account. In other cases, a simple bank guarantee is agreed upon.

” In the event of inaccuracy, incorrectness or untruthful information, the buyer of the company can be compensated for the caused damage, a contingency or a loss. For this purpose, liability warranty clauses are established.

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.

4) Limitations on Responsibility

Usually, there are limitations to the seller’s responsibility regarding responsibility with the Treasury, Social Security, or Third Parties. There are also time limits on liability claims, except for the cases of tax, labour, social security or administrative contingencies, where the time limit coincides with the legal prescription.

The contract usually sets a minimum amount of responsibility above which the seller’s liability can be discussed, so that the parties eliminate the possibility of any minor issues. For each transaction, depending on the size, the amount will be that in which the parties feel comfortable in structuring the agreement.

5) Conditions

The conditions include, among others, non-compete clauses. These clauses serve to prevent the seller from setting up a parallel company and taking customers away from you. It serves to protect the company’s goodwill.

Sometimes a contract of sale is signed conditioning the closing to the fulfillment of certain milestones such as obtaining authorisations, assignment of contracts or that the seller carries out certain operations in advance (the sale of a plot of land or its appropriate legalisation in the corresponding register).

Annexes

The annexes are a part of the contract that has a legal value. They include due diligence, financial statements, patents, certificates of compliance with Social Security, Treasury, etc.

If you are considering to sell 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.

Binding offer or letter of intent

In a buying or selling transaction, a formal agreement on the main aspects of the sale is usually required for both parties. In M&A, this is known as a binding offer or letter of intent. This offer formally guarantees you that the intention of your counterpart is the same as yours.

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.

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, the 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.

 You may also be interested in: The sale and purchase agreement (SPA): what should it contain? 

 

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. 

How to value a company? The usefulness of the business valuation process

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.

First of all, it is essential to differentiate the value of a company from its price because the two terms mean different things: A price of a company is a specific value of a company materialized at the moment of sale and 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.

Table of contents

 

 

Importance of Conducting a Business Valuation

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 key value generating areas of the business. It is important to consider which areas of your business may be of specific interest or value to the counterpart of the deal, as this will essentially determine the valuation results. For example, depending on the mindset and objectives of 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, there are certain key factors that must be taken into consideration. These include:

1. Profitability and risk.  Essentially 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 fast will be of priority over selling at a fair value due to any personal or emotional reason that may be the case. It is therefore important 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 high multiple volumes, your company will be worth more independent of its intrinsic value, compared 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 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. Good valuation requires valid information. Before considering performing a valuation and making future value predictions, it’s important that the company’s past and present data is accurate and valid. 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 Company 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. Special attention should be also paid to the factors that might affect future financial projections To prepare this, the function should include revenues, costs, profits, investment plans, projected cash flow and the financial structure of the company. This projection will act as a hypothesis about future financial data (balances, income statements etc.).
In addition, 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 with respect to 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 a period of time. This time is normally a range from 4-5 years. After that, estimating an accurate value can be extremely complicated. For this reason, buyers usually estimate projections for a shorter period of 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 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 future 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 range 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 essentially 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.

Conclusions

Ultimately, the valuation process is a preliminary task to sell your company. It provides insight into the key areas of a business allowing owners to leverage on 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, but by knowing the characteristics of the company and its corresponding environment, the best fit method can be chosen from a variety. It is an absolutely essential process to be able to maximize the price of the company backed by logical reasoning and numerical arguments.

The business valuation is an absolutely 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 valid 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 good 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 changes 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.

Increasing the Firm’s Value in an M&A Deal

Increasing the Firm’s Value in an M&A Deal

The primary objective for most sellers in an M&A transaction 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!

Five reasons to ride the M&A wave today

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.

 

@EnriqueQuemada