Category Archives: Finding the Right Buyer

Five Recent Examples of Acquirers Paying a Premium

What are buyers looking for in acquisition targets?  The objective of an acquisition is to create value.  This is accomplished by improving profitability and/or reducing risk; both enhance earnings quality and drive value.  More specifically, acquisition objectives can include achieving economies of scale or economies of scope, vertical integration, securing access to talented management, unlocking underutilized assets, gaining access to proprietary technology, increasing market power, shoring up weaknesses in key business areas, geographical or other diversification, to reach critical mass for an IPO or to achieve post IPO full value.

Below we list the rationale for paying a premium behind five recent real-life transactions.

To Maintain or Improve its Competitive Position: This may be the most common motivator for acquisitions by large companies such as Oracle or Cisco.  With the rate of change in the tech sector as fast as it is, it is a lower risk strategy to wait until a new solution is proven and a sector leader has emerged than pursuing this organically.   Acquisitions of this nature achieve a number of risk reducing objectives including strengthening customer relationships.

To Improve the Revenue Mix to Higher Valued Revenues:  Ever since hosted recurring revenue models (SaaS) came into existence, revenue quality has been a hot topic.  In this case the buyer was a public company and a large share of its revenues were of a product reseller nature.  These types of companies typically have a large customer base that they want to sell more products and services to.  The goal is to improve revenue quality.  Potential revenue quality improvements include moving from distribution to higher margin VAR (consulting), or from consulting to support/maintenance (recurring revenues) and, ultimately from support/maintenance recurring revenues to sticky, mission critical recurring (cloud application) revenues.  Acquisitions of this nature create value by improving revenue quality resulting in a higher valuation multiple.

To Fix Underperforming Parts of the Business:  In this case, a large company had a small division that fulfilled a necessary component in the value chain.  The division had HR challenges and was underperforming.  Not only did the seller have a superior technology but it also had a very knowledgeable management team that would become a great asset to the buyer.  The buyer was able to pay far in excess of any other interested party and stood to benefit much more as well.  Finding a buyer that can benefit from multiple aspects of a seller’s business is rare but when it happens, a very good deal is possible.

To Unlock the Potential of Underutilized Assets: In some cases, proprietary resources such as R&D, patents, proprietary processes and technologies and even personnel are underutilized because of limited access to capital or other constraints.  Acquisition by a more, well-resourced company can unlock value in these assets.  Acquisitions of this nature typically achieve revenue and/or margin improvement.

To Achieve Full Value as a Public Company: Reverse Takeovers (“RTOs”) are an active part of going public in Canada.  However, in some cases, once public, the company’s share price languishes as there isn’t sufficient value or liquidity to attract analyst coverage.  With publicly traded shares as available currency, an acquisition strategy will increase the share float and diversify the investor base.  In time, costs will have to be rationalized or synergies achieved in order to evidence margin improvement.  The stronger business attributes combined with improved trading liquidity will realize full value over time.

While the situations outlined above sound like textbook cases, in the real world, the stars don’t line up to create a premium sale as often as one might think.  The timing has to be just right, where the buyer-target fit is considered a high priority and the target business is of sufficient size (and that typically means having grown beyond start-up) to be worth the effort.  A managed sale process can bring a number of interested parties to the table and help identify the rationale to drive exceptional sale value.

What Makes a Good Buyer?

Now that we have constructed the buyer list, what really went into the thinking of who to include?  What are the buyer list criteria?  I have outlined several considerations in my previous post but another way to look at it is as follows: identify companies with an ability to pay and an interest in paying a premium.

Assessing the ability to pay in the private market space is difficult.  While for public companies you can peruse their financial fillings, private company information is usually based on voluntary disclosure and may be out of date.  The other area where ability to pay is difficult to assess is if the company has a relationship with a private equity group.  The company may appear small and unable to acquire but the private equity group may have access to hundreds of millions of dollars.

With respect to paying a premium, the rationale for doing so may be:

  • Economies of scale
    The combined company can often reduce its fixed costs by removing duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit margins.
  • Economy of scope and cross-selling opportunities
    Economies of scope are attained when, for example, efficiencies are gained by increasing the scope of marketing and distribution to additional products (sometimes creating product bundles as seen in the Telecom sector).
  • Unlocking underutilized assets
    In some cases proprietary resources such as R&D, patents, proprietary processes and technologies and even personnel are underutilized because of limited access to capital or other constraints.  Acquisition by a more well resourced company can unlock these assets.
  • Access to proprietary technology
    In some cases start-up or R&D focused companies have developed technologies that can have an immediate and broad impact on the operations of leading incumbents and substantially improve their competitiveness.
  • Increased market power
    Acquiring a close competitor can increase market power (by capturing increased market share) to set prices.
  • Shoring up weaknesses in key business areas
    When talent is hard to attract, acquiring businesses that perform functions that are under performing can be an efficient way to fill gaps.
  • Synergy
    An example of synergy includes increased purchasing power as a result of bulk-buying discounts.
  • Geographical or other diversification
    Acquisitions can achieve immediate access to new geographic or product markets.  In some cases this can also serve to reduce earnings volatility.
  • Providing an opportunistic work environment for key talent
    Growth through acquisitions provides managers for new opportunities for career growth and advancement.
  • To reach critical mass for an IPO or achieve post IPO full value
    Larger companies typically have more financing options thereby reducing capital risk.  Once public, companies need sufficient trading in their shares to realize full value.
  • Vertical integration
    Vertical integration occurs when a company acquires its supplier and can result in significant savings if the supplier has substantial market power.

Determining beforehand whether a private company has these goals or can potentially achieve these results is nearly impossible.  The best way to find the company that will pay the most is to approach all possible buyers, talk to them and discuss the possible fit.

What Will a Strategic Buyer Pay?

Now that we have identified reasons for paying a premium; what is a premium? By definition, it is higher than the average price.  But if the market will ultimately determine the price, where do you start?

You start with the notional value.  A notional value determination is one in absence of an open market transaction, in other words, intrinsic or stand-alone value.  The notional value of an enterprise does not include what a strategic acquirer can bring to the operations (i.e. with a distribution network or sales force, etc.)  The notional value is determined through an extensive analysis of the company’s financial performance and market opportunities typically by applying a Discounted Cashflow Analysis (DCF) and/or a public company market trading and acquisition comparable analysis (I will provide more details regarding valuation analysis in a later post).

The notional enterprise value is driven by earnings and earnings potential and the risk associated with generating those earnings.  Earnings may be generated by levered or unlevered assets.  Enterprise value consists of term debt and equity (assuming a normal level of working capital), so if there is debt in the company, it must be subtracted from enterprise value to get to equity value, which is the net amount a seller can expect to receive.

A premium is the amount a buyer will pay, over and above the notional value, however, how the purchaser is being valued is a factor in this equation.  Only in rare cases will a buyer pay a price that is dilutive to the acquiring company’s forecast earnings.  An example is acquiring technology; whether it is a patent that doesn’t generate any direct revenues or whether it is a company that is losing money presently but is expected to be very profitable in the future.  In cases like this it may make sense to accept short-term dilution to earnings (i.e. an investment in future earnings) from an acquisition.

The norm is that an acquisition is accretive to the purchaser’s earnings.  An example of an accretive acquisition is best illustrated with an example of a publicly traded company (Company A).  Say Company A trades at 12 times EBITDA of $10M (i.e. an enterprise value of $120M) and the target is purchased at 7 times EBITDA of $1M (a price of $7M).  The go forward enterprise now generates $11 million (excluding synergies) and with a multiple of 12 (assuming the market likes the acquisition and views the pro-forma combined company as having similar prospects), the enterprise value is now $132M.

While the example is simplistic, the concept that I want to highlight is, what if the notional value is $5M?

Perhaps during a divestiture process there would have been several expressions of interest at $5M but the winning bidder had to pay more.  Company A could have paid $10M (10 times EBITDA – as it trades at 12 times EBITDA) and it would still have been accretive.  How much of a premium should Company A pay? This is the technical dance; the grey area between the intrinsic value and the value to a buyer.

So what will a strategic buyer pay?  They will pay somewhere between the notional value and the value to the buyer.  Creating a competitive bidding environment can persuade the winning buyer to pay more than the notional value and share some of the value to the buyer with the seller.

What Will a Financial Buyer Pay?

Now that we have examined the logic that drives a strategic buyer, what logic drives a financial buyer?

First of all, what is a financial buyer?  A financial buyer is one who is buying strictly for a financial return.  Financial buyers include individual investors, who have either saved up or cashed out, and institutional funds such as Venture Capital Funds, for early stage high growth opportunities, and private equity funds, which come in many varieties (including Leveraged Buyout, Growth Capital, Distressed and Mezzanine Funds).  There are over 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds such as BlackRock, Onex and Kohlberg, Kravis Roberts.

How does a financial buyer compete in a world with well capitalised strategic buyers?  Two ways: leverage and portfolio tuck-in acquisitions.

If cheap credit is readily available (i.e. leverage) then financial buyers can be very competitive.  Here is an example.  Company A, a stable profitable company, generates $10M of EBITDA per annum and a financial buyer is prepared to pay the notional value, let’s say it is 5 times EBITDA or $50M.  In this case, assuming no growth, the financial buyer will expect an ongoing stream of EBITDA of $10M or a 20% return on capital per year.

Let’s say a strategic buyer is willing to pay 6 times EBITDA or $60M…. how does the financial buyer compete?  In a word… leverage.   By using 50% debt and 50% equity, the financial buyer can pay $65M and generate a similar risk-adjusted return on capital deployed.  Here is how it works.  The financial buyer secures $32.5M in debt financing (at 3.25 times EBITDA this will likely include subordinated term debt (“sub-debt”) as well as secured bank operating and capital loans) at a combined rate of 8% per annum.  Now the company earns $7.4M after debt interest payments and the net capital (equity) used is only $32.5M, so the return on equity is now 22.8%, on a risk-adjusted basis close to the 20% originally targeted (one could argue that a higher risk adjusted return is required but the point is made.  More about the risk-return equation later).  How did this come about?  Secured debt is a cheaper (and tax deductable) form of capital than equity and, therefore adding debt to a capital structure – while it increases the risk – concentrates the return on equity and can improve equity value.

Another way a financial buyer can compete with a strategic buyer is to look for tuck-in acquisitions.  Financial buyers typically look for opportunities where they can make additional acquisitions in the space to grow the company to a meaningful market position and enhance value by building a larger, stronger competitor.  The financial buyer’s first acquisition in a sector will be for a target financial return but with the foresight that subsequent acquisitions will build incremental value.  In this case, a financial buyer becomes a strategic buyer.  I said earlier that financial buyers buy strictly for a financial return but in many cases financial buyers envision growth strategies that make them quasi strategic buyers.

So who will pay more?  A strategic buyer or a financial buyer?  I can think of examples where both financial buyers and strategic buyers have paid seemingly exorbitant sums for companies (for example Goldman Sachs buying into Facebook at a $50 billion valuation (over 30 times run-rate revenues) and HP buying 3PAR for 11 times revenues) but if I were to look at the average transaction, I would say strategic buyer.

Constructing a Buyer List

The first step in constructing a buyer list is having a conversation with the owner of the business.  He/she will know the immediate competitors they face every day and why or why they will not be “good” buyers.  They will also know the reputation of these companies in the marketplace and may not want their legacy in such a company’s hands.

It is important to understand all of the objectives/considerations of the seller.  Realizing the most money possible is the obvious goal but is it also to leave a legacy? ….to provide continuation and opportunity to the staff? ….to retain the brand? …the local employment base?

Acceptable acquisition structure and transaction timeframe are also important considerations in constructing a buyer list.  Does the seller want to exit as soon as practical (usually a minimum of six months post close) or does he/she want to continue to lead the company as a division of a larger, perhaps public entity, and in this circumstance, he/she may be more comfortable with an earn-out or accepting shares of the purchaser as consideration (more on all of the potential structures later).

M&A advisors will use many resources to prepare a buyer list including proprietary in-house databases, existing relationships in industry and the private equity and fund sectors, business networks, associations, and commercial company databases, some containing as many as 15 million companies world-wide.  These databases allow for searching by revenue/profit size, geography, key words, business description, NAICS codes (a government approach to classifying industries) and also by number of funding transaction and M&A transactions.

The buyer list is an evolving document.  While an advisor has tremendous resources and many relationships at his/her disposal, they will never identify all potential buyers before engaging in the process.  Once the teaser is in play, recipients (particularly private equity groups) will sometimes suggest other interested parties.  Sometimes, private equity groups will have investments in companies (or relationships with companies) that are not obvious.  These days companies can evolve from an idea to a funded and well strategically aligned early stage company in a matter of six months.  Databases and M&A personnel have a hard time keeping up with this level of activity.

Entrepreneurs often exclude direct competitors from a buyer list for the obvious concern that the competitor will use the information that the seller is for sale a sales tool against them OR they may wish to feign purchase interest only for reasons of gaining competitive intelligence.  Excluding direct competitors may or may not be an issue from the perspective of realizing full value in the sale process.  I have found that rarely does the obvious buyer turn out to be the actual buyer.  Direct competitors may be undercapitalised or they may have very similar products where very little synergies are realised in the acquisition.  For example, they may just want the customer base and then lay off staff and replace the solution.  This may not be a desired outcome.