Price is often the number one focus in mergers and acquisitions and everyone is eager to get down to the numbers.

However, as you might expect, buyers and sellers have very different expectations on price, which can lead to friction between the two parties. On the one hand, most sellers plan to offer their business to the highest bidder while buyers are looking for a cheap deal. Given the opposite viewpoints, it can be difficult to broach the issue of price and come to an agreement.

The best way to bridge this gap is to make sure you don’t focus on price as a primary driver for the acquisition. Before you even begin talking about dollars and cents, you should make sure the deal makes sense. Initially you should communicate the strategic value of why an acquisition between your two companies makes sense. This is a critical step, especially when approaching owners of not-for-sale companies. Aligning your vision with the owner’s vision prior to even discussion the details of a potential deal (such as price or deal structure) is paramount.

Once you’ve achieved strategic alignment and you begin negotiations, you must think about what you can offer an owner in addition to price that will convince him or her to sell to you. Money is a strong motivator, but it’s not the only motivator. As a buyer, you must identify the nonfinancial factors in addition to price that will motivate an owner to sell. Understanding the owner’s psychology is key to building a mutually beneficial deal.

Owners do sell their businesses for many reasons other than high price including:

  • Age – They may want to retire and are burned out
  • Family – They may have no heir to take over the business or their spouse may be nagging them to retire
  • Insecurity and risk – Selling now while the business is performing well may mitigate their risk
  • Excitement – They simply are excited to be considered for acquisition, because of the prestige or a possible financial windfall

Achieving strategic alignment before discussing price as well as identifying the issues that matter the most to the owner can help you bridge the gap between your number and theirs. When you approach owners with a complete understanding of all the different factors that are important to them – age, community, family, financial, and risk – you increase your chances of building a successful acquisition.

Many are convinced that the buyer with the most money always wins the deal. Although many acquisitions by financial acquirers and strategic buyers are driven by the desire to grow revenue and the company’s bottom line, it is possible to win an acquisition without offering the most amount of money.

A successful acquisition is about finding the right equation for the seller, which includes, of course, financial compensation, as well as many other non-financial aspects including prestige, value, excitement, or strategic fit.

It can be difficult to visualize this concept, so let’s take a look at a recent example from the news. Amazon announced it would acquire Souq.com a Dubai-based internet retailer. While terms of the deal were not disclosed, Amazon reportedly paid between $650-750 million, beating out a competing offer for $800 million from Emaar Mall. So why would Souq sell to Amazon for a lower price?

From Amazon’s perspective, this deal makes a lot of sense because it will allow Amazon to enter into the Middle East while circumventing regulatory hurdles, the headache of building new infrastructure, and the cost of raising brand awareness. Souq.com is already a very popular in the Middle East where e-commerce is expanding among a growing young, tech-savvy population. Kuwait, Saudi Arabia and the UAE are the top markets for mobile penetration. In addition, Middle Easterners are willing to pay a 50-100% premium for Western products and brands from the US. The Souq acquisition will help with top-line and bottom-line growth.

So what’s in in for Souq? Why agree to a deal for less money?  The answer is Amazon’s experience and reputation. As one of the top global companies, Amazon has a large network, resources, and deep experience with e-commerce. Souq can leverage Amazon’s experience to continue growing.

It is also exciting to be acquired by a well-recognized brand and be a part of Amazon’s team. While we can’t know what the founder of Souq, Ronaldo Mouchawar, was thinking, we can safely assume emotion had some factor in the decision-making. Don’t completely forget about the human factor and emotions when it comes to M&A, especially when dealing with owners and privately-held businesses. In fact, understanding the owners motivations – excitement, family-members in the business, community pride, desire to leave a lasting legacy, risk aversion, or financial – is key to developing the right equation to persuade him or her to sell.

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The Guideline Public Company (GPC) Method is one of the more popular valuation methodologies because people often hear about it in the news or in presentations. This method identifies prices for individual shares of publicly traded companies that are subject to the same industry dynamics as the subject company (the company you are trying to value).

The valuation multiples calculated from these companies provide an indication for how much a current investor in the marketplace would be willing to pay for similar situated company that we are trying to value. For comparison sake we might be looking at things like similar businesses, sizes, geographic regions, and other operating characteristics.

Is the GPC Method Appropriate for Middle Market Businesses?

Depending on the size of the subject company, using the GPC method can be hard to implement realistically. Many middle market companies are better suited for the completed transaction method or the Discounted Cash Flow (DCF) approach. However, for some industries such as cloud or information technology, GPC data can be very robust and indicative of what’s going on in the industry, even for smaller-sized companies.

Selecting Guideline Public Companies

There are a number of resources both paid and free that we use to identify guideline companies.

  1. Cap IQ – This is a paid resources that provides research and analysis on publicly traded companies and overall market awareness. You’ll be able to use the Cap IQ database and tools to identify a list of companies that are similar to the one you are trying to value.
  2. Securities and Exchange Commission – The SEC has a search tool called EDGAR that allows you to search by industry code and provides a list of all public companies that characterize themselves as being in that industry. This typically generates a lot of results which you’ll need to narrow down in order to make sure the public companies are really comparable to the subject company.
  3. Yahoo Finance / Google Finance – These online tools provide key data on publicly traded companies. Once you find a few good comps for your subject, you can look up their competitors on Yahoo or Google Finance and start developing your list of GPCs that way.

How Many Companies Do You Need?

For a good GPC you need at least five public companies in your comp set; we prefer to have at least 10. It provides for a lot more analysis for the range of industry multiples. I’ve seen as many as 30 companies used, but bigger is not necessarily better. When using the GPC method, you really have to ask, “Is the subject company really comparable to these public companies?” And if this causes you to whittle down your comp set to five or six companies, that’s fine.

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Monsanto has rejected Bayer’s all-cash $62 billion bid, but says it is open to negotiations. A combination of Bayer and Monsanto would create the largest seed and pesticide business globally with $67 billion in sales. While you may not be creating an agricultural behemoth with your acquisition, there are a few lessons we can learn from this transaction, regardless of size.

M&A Will Affect You…How You Respond Is Your Choice

One of the reasons Bayer wants to acquire Monsanto is because of consolidation in the agriculture industry. Last year chemical giants Dow Chemical and DuPont agreed to a deal that will combine their agriculture businesses. Earlier this year Syngenta, a Swiss pesticide maker, agreed to be sold for $43 billion to China National Chemical Corporation.

When acquisitions occur in your industry, they affect you whether or not you decide to pursue M&A. A major acquisition by a key player may change the market environment and industry dynamics and you’ll need to find ways to adapt to these changes. This may mean changing your approach to customers, developing a new product, or pursuing strategic acquisitions yourself. Whatever you decide to do, remaining static and maintaining “business as usual” is not the best path to success.

Price Isn’t Everything

The Bayer – Monsanto deal is a publicly traded transaction and so it must be reported in the news and to investors. With all the media surrounding the deal, all the information is available to not just the public, but Bayer’s competitors. It’s interesting that Monsanto has rejected Bayer’s offer as “incomplete and financially inadequate,” but is open to further discussions. In other words, Monsanto believes the offer is too low and would like a higher price.

In contrast to large publicly traded companies, privately held firms execute acquisitions a bit differently. First, there is no need to announce each acquisition to the public. This allows you to fly under the radar and keep your strategic plans hidden from competitors. It also may help you to avoid price wars and auctions where you are competing against other bidders.

Of course, price is an important aspect of any deal, but it is not the only important factor. Especially in the world of privately held, not-for-sale acquisitions, there are many non-financial factors that can (and will) convince an owner to sell. Finding out what motivates an owner and communicating the strategic alignment of the deal are critical.

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As you might expect, sellers look for a premium multiple. Buyers typically will only consider paying a premium to market if they are adequately convinced that the value of the potential target justifies it.

This begs the question: How does one derive a rationale for discount and premium multiples on a business?

There are a number of factors that contribute to and ought to be considered when assigning a discount or a premium to a market valuation multiple. Typically when using the term “multiple,” we are referring to EV/EBITDA or EBITDA multiples. Sometimes Revenue Multiples are applied when EBITDA data is not available.

Here are some factors that buyers and sellers consider when evaluating a business that may lead to premium valuation:

Customer diversification

A more diverse customer base is looked on more favorably than a heavy customer concentration, even with a blue-chip company. The risk of a big customer leaving after a transfer of control will typically be reflected in lower valuations from a bidder. Customer diversification may refer to geographies, product lines, end-users, or market segments. Anything that reduces the risk of a significant disruption or potential variability of revenue streams is a source of valuation premium.

Financial controls and accounting systems

Are there financial systems in place? Are statements audited? Audited financial statements are especially important to buyers because they demonstrate a level of sophistication and accountability in the seller’s business. Companies with their house in order from a financial, operational and accounting standpoint will command higher multiples. At the same time, having these functions organized makes diligence quicker and easier for the buyer. This reduces deal risk and improves the probability of a successful close.

Recurring revenue streams

If a company’s revenue is more recurring in nature, it can command a higher multiple than a business that needs to find new customers in order bring in revenue. A subscription-based business is very attractive to buyers because the money keeps coming in without any additional sales. For example, Netflix only needs to sell its services one time to a subscriber. After that, each month Netflix is guaranteed $7.99 without doing anything. On the other hand with a single-sale business, the company has to expend time, money and resources to ensure another sale to keep the money flowing in.

Past growth and performance

The past is often used as an indicator of future performance and a company with a history of sustainable growth will get a premium.

Sales pipeline and voracity of projections

The bigger the sales pipeline and the quality of the pipeline, the higher the premium. The credibility of the future revenue streams is also important. The more verifiable and believable, the higher likelihood of harnessing a premium valuation based on the potential growth in the business.

Management team and leadership

The experience, track record and quality of the management team are all taken into account when valuing a business. An experience team of executives who have worked at the business for a number of years will fetch a premium.

Human resources and staff

Training resources and protocols, quality human capital, well-functioning human resource systems and a track record of retention of key employees are all important aspects to consider when assigning discount or premium. The better these structures are when compared to similar businesses, or peers, can drive higher valuations as well.

Logistics, distribution strategy and operation infrastructure

What channels does the company use to reach the market? How efficient are distribution networks? What kind of infrastructure is in place and what is its quality? Companies that need additional CAPEX to shore-up holes in this area will typically command lower valuations.

Preparation – How well is the table set for a transaction?

On a whole, how prepared the seller is for sale will affect the valuation multiple. The more prepared the seller is, the more likely the business is to fetch a higher multiple.

Buyers and sellers may evaluate some of the attributes above in order to determine if the company deserves to be assigned a discount or a premium valuation. Ultimately, however, “the right multiple” is the one that the buyer and seller come to agree on, so don’t get too caught up in the technicalities or if you’ve checked all the boxes. Depending on the particular strategic rationale for sale, one of the items above may be more important than another. Valuation aside, nothing is more important than getting the transaction rationale right. Valuation is a tool for evaluating a potential acquisition that informs us on appropriate deal structure and allows us to begin exploring financial and operational due diligence from a quantitative perspective.

This is a difficult question to answer. Of course your budget (in both human resources and dollars) will vary depending on your capabilities and the size of the transaction.

Acquisition is a substantial task to take on so ideally you would have at least one person that is 100% dedicated to running the M&A project – and really think of it as a project.

There are a few ways to look at the financial budget. First, it is likely to reflect the size of your organization. You can calculate it by thinking about how many people you would dedicate to the project. For example, if you have three to four people involved in the acquisition process, think about what it would cost you to pay those people. This can be one way to calculate a dollar amount.

Another way to approach this is to think about the size of the transaction you’re looking at. A rule of thumb is to budget about 10% of the transaction value. For example, with a  $10 million transaction you would budget $1 million for the process, including legal fees and completing the transaction.

As I mentioned earlier, this is a tough question to answer. Determining your budget also depends on the target itself. How far away it is from what you’re currently working?  The farther away it is, the more work will be involved when it comes to market research, understanding the business, and integration.

Although I can’t provide an exact equation, hopefully this post has given you some ideas.

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I’m frequently asked about the “right” price to put in the letter of intent. As you will know, the LOI is an important milestone in the M&A process, because it establishes a “gentleman’s agreement” before the formal deal is settled.  You have yet to compete due diligence at this stage, and figuring out the right price before you have all the information can be difficult. Do you go in with a high number so the seller signs the LOI? Or do you use a more modest number and risk losing their interest?

Think Before You Price

The number you present in your LOI should be a reflection of how you want your transaction to play out. Be aware of the unintended consequences of using too high or too low a figure. Each transaction is different, and buyers and sellers have different priorities, so no one number is right for every scenario.

Notice I did not say the price in the LOI should be the amount you are willing to pay or “an honest value.”  I shy away from these types of statements because they imply that both buyer and seller are on the same team. While you don’t need to be combative, your role is to strike a deal that is to your benefit, and that means negotiating effectively.

Sometimes people use a very high number in the LOI to get the seller to sign it. Then during negotiations and formal due diligence they try to identify risks so they can reduce the purchase price.  This strategy sometimes works. For example, when negotiating with a publicly held company it may be advantageous to have them sign the LOI sooner rather than later to keep momentum in a deal.

However, in other situations, especially with privately held businesses or first-time sellers, the owner may feel like you have “stolen” from them or misrepresented the transaction on the LOI. They may become frustrated and decide not to sell. Or if they do sell to you, and you intend to keep the former owner on as part of your management team, you will have a very sour relationship moving forward.

Keeping the Big Picture in Mind

When writing a price in the LOI, consider the big picture and your desired relationship with the owner. Remember, acquisition price is just one piece of that picture and there are many other nonfinancial issues that you will be discussing with the owner to come to the right deal.

How often do sellers have unrealistic expectations of their company’s value? What’s the best way for a buyer to approach them early in the process and address their concerns?

Todd Nelson, Capstone Valuation Advisor, answers:

This is a common issue where sellers hold high value expectations for their businesses. While price is not the only factor to consider when buying a business, it certainly plays a key role.

Keep in mind is that many sellers divesting a business for the first time may not understand their company value. For many, this business is their “baby,” so they may have very high expectations.

We counsel clients selling a business for the first time to go through a pricing analysis to gain a realistic understanding of the company’s value before they speak with potential acquirers.

For buyers, the way to address this issue directly with a seller is to clearly present your assumptions in your valuation model that has been developed with appropriate methodologies.

For example, the seller may believe their business is worth $20 million, but you only think it’s worth $11 million.

Walk through your valuation model with the seller. If you’re doing a DCF (discounted cash flow), show how you arrive at a value of $11 million when you discount the seller’s cash flow back at the proper rate and that is what you think the business is worth. Using the market approach, demonstrate that according to the market comps and multiples their company is worth about $11.4 million. These two methodologies should show that the business is worth around $11 million – not $20 million.

Of course, you may be willing to pay more for the company because of the strategic value or synergies you expect from the acquisition. And there are many factors other than price that may convince an owner to sell.

By presenting a sound analysis that involves reason, logic, and assumptions based on industry standards you can sometimes overcome a seller’s high expectations of their company’s value.

Although buyers usually prefer not to include price for fear of ramifications later, most sellers want to see a price mentioned in the LOI. If this is the case, I recommend inclusion. The key is to establish a narrow price range. If you believe the business is worth $35 million, then the LOI should propose a price between $34 million and $36 million. If you were to suggest a range between $30 million and $40 million, the seller would remember only the $40 million, while your board will remember only the $30 million!

More important than the price range, though, is a detailed briefing on how you arrived at your numbers. This includes a detailed list of three major inputs for initial valuation—any financial documents you’ve received from the prospect, the information you have acquired in meetings, and any assumptions you’ve had to make. You can also include charts and graphs to further substantiate your initial offer.

The main purpose of your briefing is to take some of the emotion out of the debate over price. Both sides now have a relatively objective document to work from. Transparency in the math removes much of the mystery from the price negotiations and gives you a solid basis to incorporate any new information. In particular, the assumptions that you include in the LOI place the onus on the seller to provide more accurate data. As new information arises, you can progressively adjust your calculations to arrive at the final price.

*This post was adapted from David Braun’s Successful Acquisitions, available at Amazon.com

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It’s that time of year again. The holiday season is a great occasion to spend time with family, celebrate with friends, give to charity, drink hot cocoa – and of course buy presents.  Beginning with Black Friday, holiday sales are out in full swing with retailers trying to entice consumers with the lowest prices on gifts ranging from toys to clothes to electronics.

Fixating on price is not only limited to busy holiday shoppers: For acquisitions, executives too often focus on price. Most people make the mistake of thinking that is what an acquisition is all about, but the reality is it’s more about buying the right company.

Buyers should understand there are many different aspects surrounding a deal, many of which are not financial. Sellers may find value in other incentives such as healthcare for their family or involvement in their local charity, or even in intangible assets such as understanding and trusting the buyer’s strategic vision for the future.

The fact is, you can overpay for the right company and recover. Sure, it may take you a bit longer to recoup that extra $500,000 you spent, but you will still be successful. On the other hand, you can underpay for the wrong company and never recover. Buying the wrong company brings multiple hazards.

You may save money by getting it “on sale,” but the wrong acquisition could take you in a fruitless direction, ruin your reputation in the marketplace, or compromise your technology. At that point, you could have bought it for free and still lost! It’s like buying a shirt in the wrong size simply because it’s on sale. Sure, it was cheap, but you’ll never wear it because it doesn’t fit. You would have been better not buying it in the first place.

Are you considering an acquisition? Remember, when it comes to buying companies, especially privately held ones, the transaction is almost never about just the price. There is always something going on that falls outside the spreadsheets. Understanding that mysterious ‘‘something’’ is what can make or break your deal. The statistics are frightening. By most reckonings, 77 percent of company acquisitions fail to deliver expected outcomes. Don’t be scared off acquisition as a dangerous path to take. Without a plan, it is indeed a dangerous path. But with the right roadmap  buying another company can prove the fastest, most secure, and most profitable way to grow your own. Stay tuned to my blog and I will show you a world of M&A that is both fascinating and accessible.

 

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excelI wanted to post a quick note about the difference between the valuation of a company and the price that you pay to buy that company.  This distinction came up after a conversation I had the other day with an associate who had difficulty understanding why he was looking at paying a different amount for a company than the valuation his accountants had given to him.

Valuation and price have different meanings and are (usually) two quite different numbers. A company’s valuation is the financial assessment of a business determined by one or more accepted valuation methods, such as Discounted Cash Flow.  Valuation’s main purpose is to figure out a ceiling for what you could pay for the prospect.

The price is the dollar amount that will be negotiated in the acquisition agreement. Remember the core premise that every company is for sale for the right equation. The valuation will certainly form a major part of that equation, but there is no reason to assume it will be all of it.

One of the factors that often must be mitigated is the owner’s ego. For example, your valuation methods may place the value of a company at $35 million, but the owner passionately believes his firm is worth at least $40 million. When constructing your initial offer you may have reason to take into account the owner’s expectation of what he will get for his company.

Other factors that can force a gap between price and value include historic transaction multiples in the industry, revenue replacement issues and even the rumor mill.

I urge you not to throw around the terms price and value synonomously.  As you can see, they are quite distinct. A solid understanding of their differences is essential when discussing dollars and cents during negotiations.