Valuation in M&A deals

Price is always the most important consideration in an M&A deal. After all, you are entering into an M&A deal to make a profit. So, all of the valuations should be geared to increasing this profit.

Valuation is thus, a core part of the transaction life cycle. It enters the life cycle in the negotiation phase, where it is negotiated by the parties, and continues well beyond post-M&A integration. It continues to feature in post-integration discussions while evaluating synergies.

There are various methods of valuation that depend on the following factors:

1.????The Nature of the Company. The valuation is influenced by the nature of the business i.e., whether it is a going concern, bankrupt or under liquidation etc.

2.????The Company’s Growth Stage. A company in the infancy or high growth stage will have higher valuations because of their future profitability. But a company in the decline stage will be valued considerably lower.

3.????Cost of Starting a Similar Business (Starting Cost). If you can start a business in the target industry operating on the same scale as the target, the deal’s valuation decreases because you are paying for something you can do yourself. However, valuations increase where it would be difficult for you to start such a business as the costs are too high.

4.????Performance History and Future Prospects. As a company’s past performance reflects its efficiencies and profit-making capabilities, it would be valued higher. Similarly, positive future prospects of the business in its industry and market will also result in higher valuations. Thus, there is a positive relationship between the two.

5.????Percentage of Recurring Revenue. Businesses generate some recurring revenues i.e., those that are guaranteed and received on a timely basis. For example, standing contracts with customers for a monthly supply of goods or services, auto-renewal subscriptions, etc. Thus, the greater the percentage of recurring revenues generated by the target business, the greater the valuation.

6.????Churn/retention rate. Churn Rate is the rate at which a certain group of people are leaving the company. This can be customers or employees. Both Customer Churn Rate and Employee Churn Rate are important components of business valuation. If you have a high Customer Churn Rate, it means that the business is attracting customers, but unable to retain them. The same applies to Employee Churn Rate. You continuously expend resources to attract customers and employees but do not gain profit from it.

Customer Churn Rate = (No. Of Lost Customers During the Period/Total Customers at the Beginning of the Period) * 100

Employee Churn Rate = (No. Of Employees fired/resigned during the Period/Total Employees at the Beginning of the Period) * 100

Exclude employees made redundant due to business reasons while calculating this ratio.

7.????Gross Margin. This is the gross profit (or loss) margin at the end of the financial year before deductions of tax, interest, and dividend are made from it. This is the basic value that shows whether the target is a profit-making or loss-making enterprise. Thus, you can understand the impact it has on valuation.

8.????Customer Acquisition Costs. These are the costs that the target is incurring to attract and retain customers. It has a direct relation with Customer Churn Rate, Marketing and Sales Costs of the company. If you have a high Churn Rate, as discussed, you will have to spend more on marketing, advertising, and sales promotions. All of these costs together make up your customer acquisition costs. A company with a high cost is not so attractive–unless you are able to identify why it is failing to retain customers and strategize and implement an effective plan to retain customers.

9.????Addressable Market Size. As discussed in Part A, often M&A deals are made to penetrate new markets, niche areas with high returns, or new technologies in existing markets. If you acquire a company that already has a high share within its market, you are gaining a greater advantage from market positioning. Hence, the business’ valuation increases. The opposite is also true. If the target has a small market share or operates in a small market, the advantage and growth opportunity is also less. Hence, its valuation decreases.

10.?Competition. The type of competition in the market depends on the product, nature, and growth stage of the industry. For example, if there is a monopoly (no competitor), oligopoly (very few competitors) or monopolistic competition (number of competitors exist but there is product differentiation) in the market, the seller has considerable power to set prices. Additionally, if the industry is in its idea, development or growth stage, there is scope to reap great profits and milk the product for all its worth. Thus, it will be highly valued.

?What You Need Before You Value

The following information is required for an accurate valuation. Make sure to gather this data from the other party.[1]

1.????Financial statements. For the last five fiscal years, including balance sheets, income statements, schedules, and records of cash flows. Most recent interim and fiscal year-to-date financial statements, including detailed balance sheets and income statements. Include statements for the same year-to-date period of the previous fiscal year.

2.????Strategic documents. Any budgets, forecasts, or business plans or projections which have previously been prepared.

3.????Copies of all existing contracts:

???????????????????????(i)?????????Franchise agreements;

?????????????????????(ii)?????????Supplier agreements;

???????????????????(iii)?????????Distributorship agreements;

????????????????????(iv)?????????Customer agreements and contracts;

??????????????????????(v)?????????Lease agreements;

????????????????????(vi)?????????Loan agreements with banks or other lenders;

??????????????????(vii)?????????Non-compete agreements;

????????????????(viii)?????????Any other legal agreements or contracts.

4.????Shareholding information. Stake of all the promoters, shareholders, directors, employees, investors, etc. in their holding patterns, and listed by class.

5.????Previous shareholding transactions. Terms, prices, and contracts related to past deals.

6.????Other offers. Information regarding the past, present or potential future offers to buy or sell part or all of the company’s membership interests, shares, or assets, even if only preliminary. This includes disclosure of discussions with any potential buyers and information on offers received; any marketing information or other documents prepared to solicit purchasers for a public or private offering of membership interests, shares, or assets, or to raise venture capital or financing; and copies of business plans prepared for potential buyers, investors, or lenders.

7.????Related party transactions. A list of all the related party transactions in the past, currently undertaken as well as future contemplated ones.

8.????All contingent assets or liabilities not reflected on the balance sheet:

·??????Pending or threatened lawsuits

·??????Regulatory compliance requirements

·??????Warranty or other product liability

·??????Hazardous waste/environmental liabilities

·??????Income Tax disputes, audits, or tax liens

·??????Letter of credit liabilities

·??????Judgements or liens on any property

·??????Company obligation guarantees

·??????Pending, threatened, or actual default—or acceleration of—leases, loans, or financing agreements, or non-compliance with the loan, lease, or financing agreement terms and conditions

·??????Any other assets or liabilities not shown on the company’s balance sheet as of the valuation date

9.????Information related to:

·??????Recent, pending, or possible future loss of customers, distributorship rights, key product lines, suppliers, or financing sources

·??????Recent, pending, or potential future additions of key product lines, customers, suppliers, distributorship rights, or financing sources

·??????Recent loss of key employees that may damage the value of the business through a loss of revenues or result in the establishment of a competing company

·??????Pending or potential acquisitions of other companies or assets

10.?Existing Valuation amounts. Of asset values, latest property tax assessments and real and personal property appraisals of company assets.

11.?List of all assets and liabilities not used in daily operations. Information on investments, real estate, marketable securities, assets held for personal use or sale, and cash value of life insurance.

12.?Non-Recurring incomes and expenses. Information on non-recurring income or expense items in the last five fiscal years prior to the valuation date.

13.?All material factors. Information that can impact or potentially impact the company or its value as on the valuation date.

14.?List of all Intellectual Property owned by the Company. For example, patents, copyrights, trademarks, designs, technical know-how, etc. held by the company.

15.?Statement of Revenues and gross profit. Calculated by-product from the last fiscal year prior to the valuation date.

16.?Most recent values of immovable property. Of the company-owned real estate, prepared by state-licensed and certified appraisers.

17.?Additional information. Anything further that may be required for accurate valuations.[2]

?

Valuation Methods

1.????Using Balance Sheets

The values in the balance sheet are looked at to arrive at the valuation figures. All valuation methods need sources of information from which they can derive figures to calculate the value of the business. Using the figures in the balance sheet is a traditional approach as it uses historical i.e., past figures to calculate the current and future values of the assets and liabilities of the company. Thus, it is not accurate. It ignores intangible assets like goodwill, brand value, patents, copyrights, designs, trademarks, technical know-how, and other intellectual property, along with client lists, and quality of human resources and management. The methods which use balance sheet figures are: Book value, Adjusted book value, Liquidation value, and Replacement-cost value.

??????i)?????????Book Value

The book value of a business is the value of its assets less its liabilities.

Book Value = Total Assets – Total Liabilities

This method suffers from the same disadvantages that all methods which use balance sheet figures for valuation, i.e., it uses historical figures and doesn’t consider intangible assets. Thus, it is not a popular method for M&A. However, it can be used to value businesses where there is not much difference between current and balance sheet figures such as banks, small businesses, non-profit organizations, etc.

????ii)?????????Adjusted Book Value

This method is a variation of the book value method. It takes the market values of the assets reflected in the balance sheet and adds the value of intangible assets not listed in the balance sheet. This method somewhat covers the drawbacks of the book value method.

??iii)?????????Replacement-cost Value

You can use this method to calculate what it would cost you to replace the assets in the balance sheet. For example, using the selling price of such assets on the market and using that price for your valuation. However, this method also does not include intangible assets and thus, is not recommended for M&A valuations generally.

??iv)?????????Liquidation Value

This value is calculated assuming that the business is undergoing liquidation. In such a case, all the assets are sold to cover the cost of debt, outstanding dues, fees, etc. Whatever amount is left will be the liquidation value that is distributed to the shareholders and owners of the company. this value will be useful to you if you are buying or selling a company that is in financial loss. In regular M&A deals, this valuation method is not regularly used.

?

2.????Profit and Loss Statement and Market-Based Methods

In the P&L statement and market-based method, the values are taken from the profit and loss statement and market data instead of the balance sheet. Hence, it is a more realistic representation of value.

???(i)?????????Market Price

The market price of shares and share capitalization values are used in this method. This is calculated by the stock exchanges for listed companies. It is variable in nature and depends on:

economic conditions,

·??????the level of activity by the company during that period,

·??????External conditions affecting the company, although there is no change in the activeness of the company itself.

Thus, the market price is not a completely accurate test of the real value of the company. Its other disadvantages are:

·??????Minority companies do not have many shares and have low market capitalization; Therefore, for them, this is not a suitable method;

·??????It is highly sensitive to financial, political and environmental changes;

·??????The prices become unstable if market activity decreases; and

·??????It is abnormally affected by any news about M&As.

?(ii)?????????Price to Earnings (P/E) Ratio

The P/E ratio is commonly used in M&A because it is an easy method. Its usage is largely observed in the valuation of private companies, which don’t have a market price as they are not listed on the stock exchange.

Hence, they compare the market price of a similarly situated company of the same industry in the market and use its P/E ratio for valuation by multiplying it with the company’s current or future values. If there is no reference company, then you can use the industry average P/E ratio as well.

However, it is not a suitable method because it involves past figures. But it can be used when all the information is not available or if there is high uncertainty.

(iii)?????????Price to Sales Ratio

The P/S ratio method is similar to the P/E ratio method. It is also multiplied by the values of the company and is derived from a similarly situated company. Thus, this ratio also has the same disadvantages.?

?

3.????Discounted Cash Flow Method

The principal valuation method used today in M&A is Discounted Cash Flows (DCF). It uses capital budgeting to value the company. It calculates the present value of all cash inflows and cash outflows over the life of the company to determine the value of the company.

Compared to the other methods we have looked at till now, which use historical values, this method uses future predicted/ anticipated values. In order to use this method effectively, the valuation expert has to consider the correct discount rate, the period of predictions and the amount expected as future cash flows. This is because of the added factors involved in M&A apart from typical investments, which are: debts, and the reactions of managers, employees, customers, and the new corporate culture.

?

Although we have provided quite a comprehensive process and explained the methods of valuation, it is always suggested that you employ experts if you are entering into an M&A deal. It’s always better to be safe than sorry!

[1] Business Valuation Checklist, The Valentium Group, Available from https://cdn2.hubspot.net/hubfs/4919325/Offers/Business%20Valuation%20Checklist%20-%20Valentiam.pdf?__hstc=161014434.d87990773cee7eede645dd8e4f36106a.1635773966324.1635773966324.1635773966324.1&__hssc=161014434.1.1635773966325&__hsfp=2176702660&hsCtaTracking=d6cb771b-5bc6-4d1d-b5dd-c6269947ed65%7Cf96a0da8-cf05-4ccb-8d14-c8cdec395a21.

[2] Business Valuation Checklist, The Valentium Group, https://cdn2.hubspot.net/hubfs/4919325/Offers/Business%20Valuation%20Checklist%20-%20Valentiam.pdf?__hstc=161014434.d87990773cee7eede645dd8e4f36106a.1635773966324.1635773966324.1635773966324.1&__hssc=161014434.1.1635773966325&__hsfp=2176702660&hsCtaTracking=d6cb771b-5bc6-4d1d-b5dd-c6269947ed65%7Cf96a0da8-cf05-4ccb-8d14-c8cdec395a21.

**************************

This is thirteenth article in the series on #mergersandacquisitions by our student researchers Swasti Patoria, Annapurna Prabhu, Astha Agarwal, Aayomi Sharma, Amrutha Alapati and Aradhya Singh, students of Jindal Global Law School (JGLS) Symbiosis Law School, Pune and Symbiosis Law School, NOIDA

For access to similar interesting articles on legal and business issues, you may subscribe to our Newsletter here https://www.dhirubhai.net/build-relation/newsletter-follow?entityUrn=6920355551797215232