Business Valuation in Mergers and Acquisitions

Business Valuation in Mergers and Acquisitions (M&A) and its Financing

Business valuation

The five most common ways to value a business are-

  • asset valuation,
  • historical earnings valuation,
  • future maintainable earnings valuation,
  • relative valuation (comparable company and comparable transactions),
  • Valuation using discounted cash flows (DCF)

Professionals who value businesses generally do not use just one method but a combination. Most often value is expressed in a Letter of Opinion of Value (LOV) when the business is being valued informally. Formal valuation reports generally get more detailed and expensive as the size of a company increases, but this is not always the case as the nature of the business and the industry it is operating in can influence the complexity of the valuation task.

Objectively evaluating the historical and prospective performance of a business is a challenge faced by many. Generally, parties rely on independent third parties to conduct due diligence studies or business assessments. To yield the most value from a business assessment, objectives should be clearly defined and the right resources should be chosen to conduct the assessment in the available timeframe.

As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right. Synergies are different from the “sales price” valuation of the firm, as they will accrue to the buyer. Hence, the analysis should be done from the acquiring firm’s point of view. Synergy-creating investments are started by the choice of the acquirer, and therefore they are not obligatory, making them essentially real options. To include this real options aspect into analysis of acquisition targets is one interesting issue that has been studied lately.

Financing

Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. Various methods of financing an M&A deal exist:

Cash

Payment by cash, Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder’s shareholders.

Stock

Payment in the form of the acquiring company’s stock, issued to the shareholders of the acquired company at a given ratio proportional to the valuation of the latter. They receive stock in the company that is purchasing the smaller subsidiary. See Stock swap, Swap ratio.

Financing options

There are some elements to think about when choosing the form of payment. When submitting an offer, the acquiring firm should consider other potential bidders and think strategically. The form of payment might be decisive for the seller. With pure cash deals, there is no doubt on the real value of the bid (without considering an eventual earnout). The contingency of the share payment is indeed removed. Thus, a cash offer preempts competitors better than securities. Taxes are a second element to consider and should be evaluated with the counsel of competent tax and accounting advisers. Third, with a share deal the buyer’s capital structure might be affected and the control of the buyer modified. If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capital increase at the general meeting of shareholders. The risk is removed with a cash transaction. Then, the balance sheet of the buyer will be modified and the decision maker should take into account the effects on the reported financial results. For example, in a pure cash deal (financed from the company’s current account), liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from the issuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economic dilution must prevail towards accounting dilution when making the choice. The form of payment and financing options are tightly linked. If the buyer pays cash, there are three main financing options:

  • Cash on hand:

    It consumes financial slack (excess cash or unused debt capacity) and may decrease debt rating. There are no major transaction costs..

  • Issue of debt:

    It consumes financial slack, may decrease debt rating and increase cost of debt.

M & A advice is provided by full-service investment banks- who often advise and handle the biggest deals in the world (called bulge bracket) -and specialist M&A firms, who provide M&A only advisory, generally to mid-market, select industries and SBES.

Highly focused and specialized M&A advice investment banks are called boutique investment banks.

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