Mergers and Acquisitions (M&A) alter the course of company goals, operations, organizational finances, and even retirement planning for the owners, whether in the near or distant future. Getting a fair and accurate M&A valuation involves complex processes that can determine the trajectory of M&A negotiations for both buyers and sellers. For this reason, understanding how M&A valuations are determined is crucial for business owners who hope to navigate these waters successfully in their favor.
What Is Evaluated in an M&A Valuation
Each M&A valuation includes several key components. Together, these quantify a company’s overall worth when selling or buying.
Financial Performance: Includes historical financial statements as well as projections of revenue, profit margin, and cash flow.
Market Position: Represents a company’s standing within the industry, including market share, goodwill, and competitive advantages.
Assets: Both tangibles (equipment, etc.) and intangibles (intellectual property, goodwill, etc.) deliver value now and in the future, as new leadership leverages them.
Liabilities: All outstanding debts and obligations must be accounted for.
Growth Potential: Projections are key here. When buying a company, they aren’t looking to buy based on the current value. They see it as an investment that will yield greater returns in the future. Investors buy potential.
M&A Techniques
Several M&A techniques exist, with each method offering a slightly different perspective on a company’s value. Choosing the right way to value a company is as important as achieving a realistic value.
Market-Based Valuation
In this method, you compare similar, recently sold businesses. This method relies on market multiples derived from comparable transactions and provides an external benchmark.
Within this method, you will need to perform the following analyses:
- Guideline Company Method: You use metrics like EBITDA multiples to compare against publicly traded companies in the same industry.
- Mergers and Acquisitions Method: To establish a value range, you look at historical M&A transactions.
Income Based Valuation
The income-based method focuses on a company’s ability to generate future income. In this technique, you discount future cash flow projections based on their present-day value using these two calculations:
- Discounted Cash Flow (DCF) Analysis: You project future cash flows and discount them using a discount rate that reflects the risk of the investment.
- Capitalized Earnings Method: In this simpler variation of DCF, you calculate the value based on normalized historical earnings and a capitalization rate.
Asset Based Valuation
This M&A valuation technique determines the value of a company by looking at its net assets and is most effective when a company has significant tangible assets. To get this valuation, you will need to calculate the following:
- Net Asset Value (NAV): You’ll calculate the difference between the market value of total assets and total liabilities
- Liquidation Value: You’ll assess the value if the company were to be sold off in pieces.
Factors that Contribute to a Company’s Valuation
It would be a mistake to overlook the many factors that can contribute to a company’s valuation. Accepting the above techniques at face value while ignoring the confounding factors could lead you to a bad buying decision. Alternatively, as a seller, it could mean leaving money on the table and wondering for years if you should have asked for more or better represented your company’s fair value at the negotiating table. This exemplifies the importance of business valuation services.
Other factors to consider include:
- Economic Conditions: Market trends and climate can significantly affect valuation now and in the future. If, for example, you were selling a trucking company that relies solely on a fossil fuel-powered fleet as the market shifts to renewable, this would certainly be a defining factor, regardless of past market performance, current assets, or income.
- Industry Dynamics: Industry-specific risks and growth prospects play a crucial role. If you were a health services company considering the acquisition of a health tech company, you would need to consider unique risks in the technology sector not present on the services side of the industry, again making industry-specific accounting experience invaluable during the M&A valuation process.
- Management Quality: The experience and performance of the management team can add or detract from value. For instance, an information technology startup with a management team of seasoned entrepreneurs with a history of successful exits may be valued higher than a similar company with less experienced leadership.
- Customer Base: A strong, diversified customer base can enhance a company’s value. For example, a construction company with a strong presence in multiple regions and a broad customer demographic can fetch a higher valuation due to its established market reach and reduced risk of revenue loss.
- Intellectual Property: Patents, trademarks, and proprietary technology are valuable assets. A pharmaceutical company holding patents for a groundbreaking drug can be valued much higher than competitors without such intellectual assets, representing the potential for high revenue generation and market exclusivity.
How to Prepare for an M&A
1. Organize Financial Statements
Make sure all financial documents are accurate, up-to-date, and ready for scrutiny. Well-prepared financial statements are critical, as they allow you to present a clear picture of your business’s health.
2. Conduct Internal Audits
Perform thorough internal audits. Take this time to identify any potential issues that could affect the valuation. This step helps you uncover discrepancies and areas that need attention.
3. Enhance Operations
If you’re considering selling a company in the future, effective exit planning is crucial for success. Focus on improving operational efficiency and profitability by streamlining processes and cutting unnecessary costs. These moves can make your business more attractive to potential buyers, as well as identify and address potential risk factors that might otherwise complicate negotiations.
4. Consider Tax Implications
Review potential tax consequences of the transaction. M&A structures have different tax implications and advantages for sellers or buyers that can become important negotiating chips. This will help you construct a favorable deal.
5. Consult Experts
Engage with M&A valuation experts. Our guidance is crucial for navigating the complexities of M&A and ensuring that you maximize the value of your business. To get the tailor-made custom business valuation services you need from the industry expert CPAs at DHJJ. Contact us to learn more.
