Pricing a company for an acquisition isn’t quite as
simple as just carrying out a traditional Discounted Cash Flow analysis. Let me
use a sporting analogy, which may make some sense. Sometimes a team seems to
pay what is far in excess the market value for a player from another team. And
onlookers says something along the lines of, “he was only worth half
that.” But if he’s the player that makes
that team complete and the team goes on to win the championship, then clearly,
they didn’t overpay.
It’s not entirely different when valuing an acquisition.
For example, some of the prevailing thinking among companies right now is that
“we will not pay more than the market price for that company.” It’s understandable in some ways: as soon as a
CEO pays over the market price for an acquisition, someone in the financial
press is going to mutter “management hubris.”
But what’s important in pricing an acquisition is its value to the buyer
and not the value which the market says. That is a conceptual difference where
the sophisticated buyers in corporate acquisitions are making a difference.
So let’s say the market is telling a company that a
firm should trade at six times it normalized EBITDA and instead, they pay seven
to eight times; does it mean they’ve overpaid? Of course, we can’t rule out the
possibility that they did. But if the
target company is special to them,
meaning that it’s a good strategic fit (just like the seemingly overpriced
player that fills the position in the sports analogy), frankly they haven’t
overpaid. This is the kind of wisdom that should drive an acquiring firm’s
maximum value before entering negotiations.
The market price suggested for the firm or something
just below it is a good opening gambit when entering negotiations. It
establishes trust between your firm and the target, in that it’s a serious
offer, while still giving you flexibility to move the price upward if
negotiations lead that way. Keep in mind that the maximum price you establish
before negotiations constitute a limit and not a target. Another consideration is
the bigger the difference between the market price and your maximum value, the
more likely it is that you’ve found a really good target. It’s important to
stress here that I would never advocate
paying over the value of what a company is worth. What I am saying is that a company’s value essentially depends on the
acquirer.
This is why the best valuations aren’t quite as
simple as estimating the cash flow of the acquired firm; there are lots of
specifics to each valuation: are you acquiring access to new markets which will
increase the revenue for your existing products? Are there synergies present in
the deal which will allow you to significantly cut back on operating costs? Does the acquisition of the firm provide you
with a patent that advance the technology your firm possesses? These are just
some of the potential questions that affect the pricing of the value of the
target to a firm, but each firm will be asking different questions.
Valuations are underpinned by the structure of the
deal. What we’re seeing for in the market at the moment is a 60/40 breakdown of
cash and equity but just as with value, this depends on the situation. The old saying,
“you name the price and I’ll name the structure,” comes into play. Therefore,
in addition to entering negotiations with a negotiation opening price and a
ceiling price for the target, you’ve got to keep in mind what concessions
you’re willing to give up for the structure: are you happy to provide promissory
notes or warrants? How much equity are you willing to give up? How much debt
should you take on?
What I hope I have shown here is that reaching the
best possible pricing and structure of a deal is an intricate process. It’s
different every time – acquiring managers are sometimes surprised at what the
target firm’s management value highly and vice versa. Above all, I hope to have
shown that by setting parameters for pricing and structure before entering
negotiations, acquiring firms give themselves the best opportunity for
maximizing the deal.
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