What will a strategic buyer pay? Ideally a premium, but what defines a premium? By definition, it is higher than the average price. But if the market will ultimately determine the price, where do you start?
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.
The notional 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 funded 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.
What About the Purchaser’s Valuation?
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 we are highlighting 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 tactical dance; the area between the intrinsic value and the value to a buyer.
Value to the Buyer
So what will a strategic buyer pay? They will pay somewhere between the notional value and the value to the buyer. The value to a buyer is a unique value that is different for every buyer. It can include calculable components such as synergies and economies of scope, but it also includes intangible components such as the value of being first to market, creating meaningful differentiation or providing an ability to enter new markets.
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.