Last year I read an interesting study by Duff & Phelps which presented the average valuation ranges of over 3,000 publicly disclosed fairness opinions over a ten year period ending in 2016 (Click here to obtain the full report in the Valuation Insights - Second Quarter 2017 edition).
Although fairness opinions are mandatory in certain instances, the basic reason why boards of directors obtain them is fear of being sued. The issuers of fairness opinions understand the stakes involved and this results in fairness opinions often being the most meticulously performed of all valuations.
Given this background, the valuation ranges from this study give a good indication of typical fair value ranges. One of the conclusions of the study was that:
"The vast majority of fairness opinions offer valuation indications that fall within 15 percentage points on either side of a midpoint"
What this means is that a transaction priced at $100m could have a fair value range of $85m - $115m. If I’m the seller I know on which end of the range I’d like the transaction to be priced!
The question any savvy seller must have after seeing these results is: What can I do to push my pricing towards the upper end of the valuation range? In the above example, if both $85m and $115m are fair values, how can I keep as far from the $85m value and as close to, or even above, the $115m value as possible?
A number of factors feed into the pricing of a business, some of which are controllable and others not. I’m going to focus on the controllable factors. There are also a number of ‘smoke and mirrors’ tactics which are employed and sometimes do work, but I’m going to steer clear of these as they can backfire and result in a loss of credibility and negotiating power.
1. A FEW PRELIMINARIES
Value vs Price
Before we get any further you need to understand the difference between value and price in the context of mergers and acquisitions (M&A). Value is what a business is theoretically worth and price is what someone pays for it. In the words of Warren Buffet, "Price is what you pay. Value is what you get". In the example above, value would be the range of $85m - $115m and price would be $100m, assuming that was the value at which the transaction was concluded. As a seller you want a price which is at or above the value of your business.
It is important to understand the value of your business in your hands. This creates a benchmark to start planning your pricing strategy. Unless you’re skilled in this area I’d suggest hiring the services of a valuation / appraisal expert to determine the value of your business. This will give you a good base to work from.
Value in whose hands?
Above I used the phrase ‘in your hands’. Your business could be worth more in someone else’s hands. The difference is due to positive synergies. ‘Synergy’ is one of those often-abused words, but beyond the fluff and buzz is a concept which is important to pricing your business.
Assume a potential buyer has well developed distribution channels, a strong sales team and a large client base. After the deal the buyer may easily be able to sell higher volumes of your product/s through its distribution channels at a relatively low marginal cost. This will enable earnings to be generated far beyond what was possible prior to the transaction. The value of your business will therefore be much higher in the buyer’s hands post-transaction than in your hands prior to it. The difference in value in your hands compared to the value in the buyer's hands is the synergy value.
Science or art?
Is valuing a business a science, an art or combination of both? It’s without doubt a combination of both, with a lot more art than you’d likely imagine. Underlying the valuation of your business is an estimate of its future performance. People are notoriously bad at accurately predicting the future in various fields and fare no better in the arena of predicting future business performance.
The implication of this is that it is impossible to definitively determine the value of a business. I can’t imagine the scenario where a valuation dispute is taken to court, an expert is called in and is able to definitively say "the value is $100m". Using the above example, what would happen, is that the expert will give a valuation range (e.g. $85m - $115m) based on reasonable assumptions. ‘Reasonability’ itself is broad so you really need to be abusing the valuation assumptions for the value to be deemed unreasonable.
I say all this to reiterate the point: the value of a business is not a fixed value but a range of reasonable values, and the range can at times be wide. As such, you want to be doing all you can to position your business to be priced at or beyond the upper end of the valuation range.
2. VALUATION 101 –THE BASICS
Keeping it simple, two valuation methodologies sit at the core of all valuations:
Discounted Cash Flow (DCF) valuation – where the future cash flows of your business and the likelihood of achieving those cash flows (or ‘riskiness’ of the cash flows) underpin the value of your business.
Multiple based or Relative valuation – where a multiple derived from a comparable company or set of companies is applied to a variable in your business to determine the value. Multiples could be applied to your business’s earnings, cash flows, revenue, book value, number of subscribers or clients, or other variables which are applicable to your industry. For example, if similar businesses have recently sold at prices based on 8x (i.e. 8 times) their EBITDA (earnings before interest, tax, depreciation and amortisation) and the EBITDA of your business is $12.5m, then applying the 8x multiple to your business’s EBITDA would result in a value of $100m (i.e. 8 x $12.5m = $100m), assuming no further adjustments to the value.
Adjustments are then made to the valuation to take certain factors into account as necessary. Adjustments could be made for:
- Debt in the business
- Excess cash
- Minority interests
- Other classes of securities
- Liabilities not provided for in the balance sheet
- Contingent liabilities
- The size of the business
- Whether the business is listed or not
- The size of the share being sold (i.e. minority or majority stake)
- Key-man risk
- Client concentration risk
- etc... adjustments are made for anything which isn't effectively captured in the valuation.
In summary then, the following factors have an impact on the value of your business:
- The future cash flows your business can potentially generate
- The likelihood of generating these cash flows, or their ‘riskiness’
- A multiple of a variable in your business
Simplifying even further, the value of your business will be determined by performance and risk. To increase value you need to increase the performance of your business and reduce its risk.
3. PULLING IT ALL TOGETHER
In a recent post I outlined the steps involved in selling a business. A key step is ‘Preparing for the sale’ and ideally this happens well in advance of the sale process beginning – even up to a few years in advance if you have this luxury.
Position your business to sell your story well
In selling your business you need to sell a story to the potential buyer. It’s like any other sales pitch; however, your story needs to be credible. You’ll likely lose credibility if you employ ‘smoke and mirrors’ tactics in positioning your pricing, so stick to the fundamentals as far as possible.
To build a credible story I'd suggest the following:
- Understand what drives the valuation of your business
- Understand where your business is current positioned and what it's likely future prospects are (i.e. build a base case set of projections)
- Build a stretch or bullish case set of projections and then start working as hard as you can to close the gap between the current position of your business and the stretch position
- Remove as much risk and uncertainty in your business as possible
- Build a story around the achievement of the stretch case which is backed by some evidence (hence the need to start this process well in advance of the sale).
This isn’t a quick fix and will involve forward planning and some hard work. Given the likely price tag, your business will be scrutinised by potential buyers. You need to position your business and pricing so that your story stands up to scrutiny.
Let’s discuss how to do this, focusing on each of the valuation fundamentals:
Future cash flows
Your future cash flows (i.e. over the next 5 or 10 years) will be based on a number of variables. Build a projection model which has the key variables of your business as inputs and push the assumption for each variable to its reasonable favourable limit. I have spent a lot of time building and working with valuation models and can tell you that a lot of small tweaks across a number of assumptions can lead to a significant change in the end result of a valuation.
Projection assumptions will only stand up to scrutiny if there is credible evidence to support them. Start planning and executing prior to the sale and build credible evidence where it is needed. Make the extra percent here and half-a-percent there (or more!) a reality. Drive up sales, negotiate hard with suppliers for discounts, move to cheaper offices if need be, cut all unnecessary or discretionary expenditure, and increase cash conversion. Get these results registered in your annual financials for a year or two (or more if necessary). Having them recorded and audited adds credibility.
Projections are also often grounded on a base year (e.g. the last set of audited financials). Registering good financial performance will give a higher base off which projections can be started. Even if your business’s performance isn’t where your projections are yet, just having the various figures heading in the right direction adds significant credibility to your story and shows that it is likely that they could get there.
Cash flow riskiness
It’s almost a certainty that projections 5 or 10 years out will not be accurate. It then becomes a question of whether there are factors in your business which make future performance more or less volatile than comparable businesses (i.e. is it easier to miss the mark?). Volatility in financial results and businesses which are considered less sustainable will have their valuations penalised.
Do all you can to remove unnecessary volatility from your business and build in practices to make it more sustainable. For example, negotiate longer term pricing contracts of your key inputs, hedge exposures to currency fluctuations, commodity prices, etc, and build in governance frameworks which make your business more sustainable without tying it up in red tape. Other sustainability issues could be key-man risk, where the business is very dependent on key management or personnel, or client concentration risk, where the business has a small number of large clients. Work hard at reducing the ‘riskiness’ of your business.
An industry may have an informal basis or a ‘rule of thumb’ for pricing transactions which guides pricing perceptions in the industry. An example is that in South Africa financial brokerage or consulting businesses are typically priced in a range of 1.5x – 2.5x revenue. I do not like using revenue multiples as a valuation methodology as they do not give credit for cost control and value extraction; however, I am amazed at how strongly this rough rule of thumb drives perceptions of value and pricing.
If your industry has such a rule of thumb, then work hard to get the applicable metric as high as possible and register this figure in your audited financials. Work hard to set plans in place to make growth in this figure sustainable and reflect this in your budgets and forecasts. If there is no such rule of thumb in your industry then look to do the same with earnings.
Understand the adjustments that could be made by a buyer and seek to reduce these as far as possible. If there is an area of uncertainty a buyer will most likely assume the worst case and work this into their valuation. As such, eliminate uncertainty where you can. If, for example, an unfounded lawsuit has been filed against your company for $10m, do all you can to get the case dropped as you don’t want the buyer even building in a small probability of this lawsuit becoming a reality (e.g. a $2m reduction in price assuming a 20% probability of the $10m being realised). As an aside, there are other means of dealing with issues such as lawsuits which don’t result in blunt pricing adjustments, but these are beyond the scope this article.
Finding the right buyer
An ex-colleague of mine in Kenya once shared the following African proverb with me: "In every marketplace there is a mad man!" If you can find the ‘mad man’ in your market who will pay a ridiculously high price then great, but you’ll more than likely rather be dealing with rational investors or buyers advised by smart people who want to buy your business for as little as possible.
This is where synergies come into play. If the buyer can extract significant synergies from your business then it is totally rational to pay a price even above the upper end of the valuation range you think is reasonable. As in the earlier synergies example, the buyer with the strong distribution channels may easily be able to sell higher volumes of your product/s through its distribution channels. When valuing the business in the buyer’s hands it could be worth $200m. If the fair value range in your hands is deemed to be $85m - $115m then paying $125m is totally rational if it gives the buyer the ability to unlock an additional $75m of value.
When working for buyers I advise them to not pay away any portion of their synergy value if possible. In a competitive process, however, it is sometimes necessary to dip into the synergy value to be able to table a winning price.
As a seller, use this knowledge as follows:
- Target buyers who can extract significant synergies from your business
- Have a competitive process (if warranted), as this can often drive prices higher
- ‘Help’ the buyer/s think through the synergy potential. When working on a large transaction once for a buyer in a competitive auction process, the seller’s investment bankers set up a ‘synergies session’ with the team to explore the synergies that could be realised post-acquisition. What helpful investment bankers!
In summary, find the ‘mad man’ in your market or a buyer with high synergy potential and pit him against other buyers (if warranted by demand).
Use the concept of anchoring in your pricing negotiations. Admittedly, this is getting close to ‘smoke and mirrors’ tactics, but I’ll mention it as it is backed by some solid research. Anchoring in negotiations is defined by the Harvard Law School as follows:
Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the "anchor") when making decisions. During decision making, anchoring occurs when individuals use an initial piece of information to make subsequent judgments. Once an anchor is set, other judgments are made by adjusting away from that anchor, and there is a bias toward interpreting other information around the anchor. (Click here for further details from the Harvard Law School)
In business pricing negotiations, be the first to table your price as this will often set the standard for the rest of the negotiations and lead to a ‘bias’ towards your initially tabled price. The buyer will likely give justifications why the price should be lower, but will be looking to move away from the higher anchored price. Lower prices can then seem more reasonable, even if they are towards the higher end of the valuation range. When you table your first price for your business, ensure that all the variables feeding into the valuation have been pushed to their reasonable limit and remain credible. This should assist in ensuring a firmer pricing ‘anchor’ at or above the higher end of the valuation range.
Valuation is not purely a science so build a good story which supports high pricing of your business then work to give your story credibility. This will take planning, time and hard work to do well. Finding a buyer who can extract significant synergies in a competitive process will also increase the probability of achieving higher pricing of your business.
All the best with your business pricing endeavours. I hope you get the price you're aiming for and trust this blog post will help you understand the valuation / pricing process and be useful in maximising the selling price of your business.
About the author
Steven Harper is the Managing Director of Helmsley Advisory, a specialist Financial modelling, M&A advisory and Valuation advisory firm based in Hilton, South Africa.
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