The CFO’s Role In Acquisition Valuation — September 2015

This post concerns valuation.

Acquisitions have been a key avenue for growth, even for small dynamic businesses. Often, talented entrepreneurs are overwhelmed by the amount of data involved in completing an acquisition. The CFO’s contribution is to help the CEO make sense of this myriad of information; understand the range of values; and assure familiarity with the associated value drivers. The remainder of this post will focus on valuation related to acquiring a business from the perspective of a strategic buyer..

From the macro perspective, in most acquisitions, the transaction price is a function of the future economic benefits the new owner of the business will derive throughout ownership. In most instances where business transactions occur, one side typically holds negotiating leverage over the other. The CFO’s role, depending upon the side of the table he (she) sits, is to provide an analysis that helps exploit the advantage or minimize the disadvantage.

In general, there are three categories of buyers:

1. Strategic buyers whose concerns include a return that indicates economic profitability and is driven in part by the buyer exploiting economies of scale, cost synergies, entrance into new markets and other strategic advantages associated with combining the acquired business with its existing operations.
2. Financial buyers whose main focus is financial return.
3. Family members, whose major interest is to resolve disputes or pass wealth from one generation to the next in the most tax efficient manner.

The basis of value for the strategic buyer to utilize is the value a particular firm (the strategic buyer) places on the acquisition candidate. This value is influenced by specific factors including the operating cash flow of the candidate, cost savings, market opportunities, excess assets to be monetized, and many others. The resultant valuation often affects the terms and structure of the transaction including financing. For the seller tax consequences are often a crucial issue.

For target companies with revenues under $1 million and fewer than 10 employees, rules of thumb often provide a good basis for assessing value. Typical rules of thumb include Price to book value, Price to sales, Price to EBITDA, Price per employee, and Price to Net Income. There are sources that compile such information notably the “Business Reference Guide” by Tom West. For larger target companies a more comprehensive methodology should be utilized.

When the CFO calculates the actual valuation, we most often recommend an income approach. Under this methodology, the estimated after tax operating cash flows of the target are forecast. In addition, benefits of new market opportunities and cost savings are calculated separately. The value of excess assets are also considered, when relevant. Each factor is quantified separately. Next, the value of the target is calculated The result provides an initial valuation upon which the CEO can begin negotiations.

The calculations imply a forecast of five to ten year period, and a terminal value both of which are discounted to their present value using a discount rate the reflects the minimum required return management expects and reflecting the risk of the transaction. The valuation should be checked against rules of thumb for medium, large, and even public companies

We believe the various components of the value described above contribute to the negotiation in that underlying assumptions can be changed separately. In our view, this provides flexibility for the CEO to devise a negotiating strategy.

When undertaking this approach, the CFO must consider attributes of the buyer and seller that are unique to the transaction. Such attributes include taxation and financing which are often important to both parties. The CFO must understand and evaluate these unique factors and structure the terms of the transaction accordingly. Such terms can include one of more of the following:

• Holdback of Proceeds in an Escrow Account
• Seller Financing whereby the seller takes a note form the buyer as part of the purchase price.
• Contingent Payment Provisions such as an “Earnout”
• Non-Competition Agreements
• Employment and/or Consulting Agreements with Key Managers
• Price Adjustments for Contingent and Unknown Liabilities

Acquisitions have been a key avenue for growth, even for small growing businesses. Often, talented entrepreneurs are overwhelmed by the amount of data involved in completing an acquisition. The CFO’s contribution is to help the CEO make sense of this myriad of information and understand the range of values and the associated value drivers. There are many reasons to value a business. The calculated value is the starting point the CFO provides for the CEO to begin negotiations and is subject to many iterations as negotiations proceed..

Capitol CFO Solutions serves clients in Washington, D.C., Maryland, and Virginia. Please contact us for a free consultation.