All banks and most private equity firms, along with publicly traded firms, need a valuation done on a prospective seller for financing purposes.
There’s no getting around this—it’s nonnegotiable.
As a normal part of our M&A work, we provide a calculation of value for both buyers and sellers as the project goes along.
Here’s how a valuation works as part of the M&A process, and why it’s SO critically important in the process of selling your firm or acquiring another one.
There are two types of valuations: Calculations of Value and Conclusions of Value.
Calculations are great for M&A and internal purposes to understand the value of a firm, and to begin to frame up the deal structure for a transaction between a willing buyer and a willing seller. Conclusions carry legal liability by the valuator and are predominately geared to litigation and IRS proceedings, where there is no willing buyer and the court must determine a share price in lieu of one.
Start with Calculation of Value
When doing buy-side representation, we start with a calculation of value for the buyer and then complete a calculation of value for each selling prospect in preparation for a letter of intent.
This helps us to determine two things:
- The financial synergies between your firm and another firm.
- The foundation for quantifying strategic synergies.
Most buyers do not realize that in doing a transaction (aside from any synergies) there is a 10% to 15% increase in value simply in becoming a larger firm. With any level of synergy and consolidation, most firms will see a 25% increase in the converged value.
When representing sellers, we start with the calculation of value to begin to shape the value paradigm in preparation for a transaction.
There is significant confusion in the technology marketplace as to the key differences between industry multiples reported about transactions and valuations.
In addition, there is a plethora of companies that look at real transactions and report crazy multiples and overinflated EBITDA, or some other benchmark. Their reports aggregate data across an industry or industry segments to provide averages, showing industry and marketplace dynamics. These data points cannot determine the value of your business, however.
Why? There are literally hundreds of things that come together to determine value.
I can’t list all of them here, but a valuation comprises economic indicators, market and financials previously mentioned, the specific risks of the company as it pertains to market position, sales pipelines, product and services offerings, competitive factors, client relationships, quality of income, intellectual property, employee loyalty, vendors, all the agreements, management quality, and more.
While these valuation points aren’t sexy, they’re necessary for a healthy transaction to take place so you don’t end up losing money or being negatively impacted in other ways.
Misunderstood Aspects about Valuations
One of the most misunderstood aspects about valuations is that they are built around a hypothetical buyer.
I’m going to get technical but not too boring … keep reading. The “”premise of value”” (key words for the valuator) has to do with why the valuation is being done and a profile of the hypothetical buyer is built upon that premise. What valuations rarely deal with are the specific synergies of a known buyer. You see, a valuation or calculation of value is an academic exercise that produces an expectation around value, but the actual value in a transaction will always be determined between a willing buyer and a willing seller at a specific point in time.
The other misunderstood element is that the terms of the transaction determine the transaction value as much as the valuation.
For instance, if the calculation of value starts the financial negotiations, the terms certainly finish the value conversation. Transaction values are determined by negotiating the risks and rewards of a given scenario.
I don’t want to get lost in all of the levers that can be pulled to determine a transaction value but … to say that if a valuation on a firm produces a value of $10M and the buyer and seller agree to an all-cash transaction at close, the buyer may get as much as a 40% discount from the valuation based upon an all-cash transaction. In this case, the buyer is absorbing 100% of the risk of the success of the transaction.
In contrast, if the seller agrees to do the transaction as an earn-out based upon a future performance, the buyer may pay as much as twice the value determined by the valuation. The buyer is often willing to do this because the transaction is usually self-funding, and the buyer only pays when the seller performs.
Transaction multiples report what willing buyers and willing sellers are willing to do. The challenge here is that, as the report reader, you have no visibility into the specific risks or synergies or the terms of the transaction that produced the reported multiples, plus each transaction is different. I am not trying to create confusion, but valuations and industry multiples provide guidance and parameters, but can’t determine true value.
True value is determined between a willing buyer and a willing seller based upon the specific synergies, risks, rewards, and terms of a transaction at a given point in time.
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REED WARREN is CEO, Certified Valuation Analyst (CVA), and Value Builder Advisor at iT Valuations. During his 30+ years working in the IT Services and technology industry, he’s provided business strategy, consulting and M&A services (60+ successful transactions) to over 250 companies across 19 different countries.
