Mergers and Acquisitions For Dummies (58 page)

Meeting in the Middle: Agreeing on a Price

Valuation is never a given. Valuation is not self-evident, nor is it obvious. Instead, valuation is an abstract concept open to interpretation. So how do a Seller, who wants a high price, and a Buyer, who wants a more reasonable price, find common ground?

During the valuation process, Sellers should signal strong valuation expectations, but fight against their own biases toward their companies. An owner who has spent years or a lifetime building a business is going to be rather subjective about the greatness of his company. But he must remember Buyers look at many potential deals every year and don't have the same emotional connection to his company that he does.

On the flip side, no matter what else they do during valuation, Buyers should be careful about bragging about how much money they have at their disposal. Sellers are liable to think a Buyer can liberally deploy that money on their deal and may develop unreasonable valuation expectations. In this section I offer suggestions for both Buyers and Sellers approaching valuation.

Testing the waters

Many Buyers ask me, “What does the Seller want?” This question is a test; I know that because when I'm buying companies, I always ask the same question! And I'm amazed at how many people (often other intermediaries) cough up a number.

As Buyer, asking for a valuation never hurts. If Seller demurs, though, be prepared to offer a valuation.

I don't recommend that Sellers offer up an
asking price
(the price they're hoping to garner). In fact, I don't provide an asking price in my deals for a simple reason: If I provide a Buyer with a certain price and she submits an offer with that price, she may be miffed if she later discovers another Buyer paid more. That first Buyer will, with good reason, say I provided bad information.

Instead, I ask the Buyer to review the information I provide in the offering document (see Chapter 8) and come up with a valuation that she can support based on that information.

I usually remind the Buyer that I am talking with other potential Buyers and try to point out certain key strengths of the business that this particular Buyer should consider as she formulates her valuation.

I also caution Sellers to have reasonable expectations. Reasonable expectations (no, that's not a mediocre Dickens novel) don't mean a Seller should undervalue his business. Instead, he should expect the Buyer's offer to be based on today's reality — financial performance, company and industry trends, market conditions, and so on — and not necessarily what that business may have been able to fetch a few years ago when sales and profits were higher and Buyers were paying higher multiples of earnings.

By the same token, though, Buyers should make an offer that is sufficient for the Seller to pay off the debts of the business. Study that balance sheet; if the offer doesn't provide the Seller with enough money to pay off debt, he probably won't be willing to essentially write a check in order to sell his business.

Buyers: Measure returns

Buyers utilize various measurements for their investments, or at least they should. A wise investor weighs the price of the investment against the expected return and then compares that expected return against other uses of that money. Simply put, the more money you pay to acquire a business, the lower the potential return. The following sections provide some common figures you can use as you measure returns.

Walking away is always an option. In addition to weighing several possible investments, you may decide that doing nothing is the best course of action, an option you may exercise with greater frequency as Sellers ask for higher and higher prices.

Internal rate of return (IRR)

Internal rate of return
(IRR), or the percentage of return that causes the expected cash flows from an investment to be the same as the cost of the investment, is one of the favorite calculations for Buyers, particularly private equity (PE) firms. Buyers usually have a minimum target return they're seeking, and if an investment's expected IRR is greater than that minimum, they do the deal.

IRR is very important to PE firms because those firms raise money from investors by touting their stellar returns. Therefore, if the investments are too pricy and the resulting yields too low, a PE fund's returns are low, and that makes raising more funds from investors difficult. Investors simply choose to invest with funds that have returned higher rates of return.

For a
strategic Buyer
(a company looking to acquire another company for synergistic reasons), the same principle applies. If a deal is too costly, the strategic Buyer doesn't do the deal. The firm looks at its other options, which may include buying a different company, investing those funds in its own company, or doing nothing. A firm may decide investing some money in the market is a safer bet than the company purchase.

Return on investment (ROI)

Return on investment
(ROI) is another favorite calculation of Buyers. You calculate ROI by dividing the company's earnings by the Buyer's purchase price. In other words, a company that generates $10 million in earnings and cost the Buyer $50 million has a 20 percent ROI.

Sellers: Create a compelling valuation

Seller should make the case for valuation and not expect Buyer to look for reasons to pay a higher price. Lucky for you Sellers, I have a four-pronged attack that, when executed properly, has fetched a figure higher than the usual upper limit of 6X. (See the earlier section “What's a Company Worth? Determining Valuation” for more on this common valuation multiple.)

But first, keep the following pointers in mind as you consider what you think your company is worth:

Take control of the process
. Sellers should be proactive in setting appointments and setting the tone for all discussions. Letting Buyer run the show doesn't usually result in Buyer willing to pay a premium.

Have reasonable expectations.
As I note earlier in the chapter, Buyers aren't as interested in how great your company was a few years ago as they are in its current financial performance, its future prospects, and the general state of the economy. Too many business owners hold on to peak year valuations, believing that those valuations should still apply.

Don't expect the Buyer to pay more for no good reason.
From my experience, one of the biggest mistakes Sellers make is falling prey to the “just because” fallacy — that is, expecting Buyer to pay more “just because.” Here's how it manifests itself in the mind of Seller:

• Just because Buyer has money, she should pay more.

• Just because Seller has a great business, Buyer should pay more.

• Just because Seller is asking for more, Buyer should pay more.

• Just because the sun rises in the east, Buyer should pay more.