Business Valuation Considerations in an M&A

By William J. McDevitt, CPA, Wilkin & Guttenplan, P.C. On May 1, 2014

Every few months, I get a call from someone planning to sell his or her business asking for a valuation report on the business. Rarely does that report ever get written. What the owners of a business who are considering selling need is very different than a written valuation report, which is typically prepared for non-transactional purposes, such as litigation or estate and gift purposes.

Valuation reports generally use fair market value (FMV) as the standard of value. Treasury regulations give the most common valuation definition of FMV as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”

However, the world of FMV is not necessarily the real world. It’s a world of hypothetical buyers and sellers. Merger and acquisition valuation deals with actual buyers and sellers and often has other considerations, such as investment, synergistic and/or strategic value.

Sellers

Sellers usually want to maximize value/selling price. However, many other considerations may come into play, such as continued employment, continued ownership of an equity percentage of the business, tax considerations and the desire to maintain continued employment for existing workers.

Sellers also need a good investment banker or business broker. The investment banker will prepare an offering memorandum to present the growth history of the business. The offering memo is circulated to as many potential qualified buyers as possible to generate multiple interested parties and includes:

• History of the business
• Financial statement history
• Adjustments to historical financial statements to normalize owner discretionary items
• Three- to five-year projections

The investment banker will also prepare financial models that indicate a range of possible values given certain assumptions. These models are generally not shared with potential buyers.

Buyers

There are several types of buyers. Synergistic buyers often want the business to broaden its offerings and/or expand its own existing footprint and typically acquire a business for the long-term. They also normally want to acquire 100 percent of the business.

Financial buyers want to acquire the business and often want to keep the current management. They may also provide incentives (sometimes equity) to management to grow revenues and profits. This type of buyer generally looks for an exit from the investment within three to seven years.

Buyers will use the offering memorandum to create their own financial models to project potential future earnings before interest, taxes, depreciation and amortization (EBITDA) or free cash flows (EBITDA minus capital expenditures). The buyers will produce a range of values using a discount, or capitalization, rate specific to the return on investment required of that specific buyer.

Do We Have a Deal?

Is there a magic price at which both the seller is willing to sell and the buyer is willing to buy? In the case of the sale of the Los Angeles Dodgers Major League Baseball team by the McCourt family to an investor group led by Magic Johnson, the winning bid was $2.15 billion. According to news accounts, the second highest bidder was $1.5 billion. Did the Johnson group overpay or did everyone else underbid?

The seller and potential buyers have a value in mind for the business based upon their perception of opportunities and risks in said business. If a transaction is to go forward there needs to be an agreement on the value (selling price) and rough purchase terms. Due diligence commences and, as a result of what is learned, the potential buyers’ views may change.

If the due diligence process uncovers perceived increased risk or diminished opportunities, the buyer may seek to modify the terms of the deal. If mutually agreeable, the buyer and seller proceed to drafting a contract, including the all-important representations, warranties and closing. Along the way, the buyers are asking themselves if they are overpaying and the sellers are wondering if they left money on the table.

William J. McDevitt, CPA, CVA, is a shareholder with Wilkin & Guttenplan, P.C. He is a member of the New Jersey Society of CPAs Business Valuation Forensic Litigation Services and Federal Taxation interest groups. Contact him at [email protected] or 732-846-3000.