How a Business Valuation Influences M&A Negotiations
A Valuation Can Strengthen & Add Context to the Seller’s Position
Going into negotiations to sell a company can be a stressful – and even emotional – experience for a business owner. In some cases, they’ve built the company and come to the point that always seemed far in the future – the point of business exit.
One factor that can give a seller confidence going into merger and acquisition (M&A) negotiations is an independent business valuation performed by a valuation professional. A business valuation helps the seller set reasonable expectations as to the price they are likely to get for the business, and it provides detailed data and information that can help defend the price if negotiations become challenging.
Most importantly, the business valuation provides an understanding of what drives the value of the company, such as strong cash flow, a steady growth trendline and low risk factors. If the data shows that a company’s performance has declined in recent years, the valuation may provide context for the owner to decide whether to wait and go to market later or proceed with the sale now and try to get the best price possible.
The Role of Risk & Growth in Negotiations
People see risk differently, so the risk component of a business valuation is very subjective and may play a role in the negotiations between buyer and seller. It can be measured through the discount rate used in an income approach to business valuation and is implied in a reciprocal of the valuation multiple. (See more below about different approaches to valuation.)
The type of buyer you’re dealing with in a negotiation may have a significant impact on how the business valuation is perceived, with some buyers being more focused on cash flow and growth and others concerned with risk. In most cases, there are two types of buyers – internal and external.
Internal buyers may include a key person or several key managers who may already be running the business and want to stay with the company, and who have the resources to buy it. Internal buyers are going to be more familiar with the company’s strong points and weaknesses and may be able to negotiate a discount on the price.
External buyers include third-party buyers, competitors, private equity companies and other unrelated parties who are interested in owning the company. They may have very different reasons for wanting the company than internal buyers would, and they are generally willing to pay a higher price. For them, the synergistic value of the company may include enabling the buyer to expand their current business with a new product line or providing a key investment opportunity.
While cash flow, growth and risk factors are the primary drivers of a company’s valuation, several other elements can influence the price during M&A negotiations. For example, a potential buyer who is a competitor in the same industry may be willing to pay a premium for the customer lists, knowledgeable employees, processes and equipment that will come along with the acquisition. Those assets, among others, will influence the conclusion of value.
Ideally, a seller would go into negotiations with a potential buyer not only with a current business valuation, but with a benchmark valuation done several years earlier that will demonstrate the improvements that have been made to the business, as well as the resulting enhancement of value.
All stakeholders will want to ensure that the appropriate methods have been used to determine the value of a company. The most commonly accepted business valuation methods and their advantages include:
- Income approach, also called the earnings approach, which focuses on income statements, net income and cash flow
- Market approach, based on the selling prices of similar companies, using transaction information or public company information
- Asset approach, sometimes used in the valuation of operating companies where the value of the underlying assets is greater than the value of the business as reflected by the earnings or cash flows
Timing & Preparation Are Essential
Timing is a key ingredient in successful negotiations over a business transaction, and sellers who want to go to market within a year are advised to do several things first:
- Set realistic expectations. There are different market conditions in each economic cycle, and a high interest rate environment can significantly impact a buyer’s readiness to engage in a transaction, especially if the target company does not have a strong cash flow. A motivated seller in such a situation may consider discounts if they’re under pressure to sell, or they can pull back and wait out the market.
- Put together a collaborative team of advisors to help navigate the waters, including a valuation professional, your accountant, a lawyer and possibly a lender.
- Become educated on valuation methods and what is involved in each. Owners who do a recurring calculation of value have a better understanding of their business and can maneuver through rougher times.
If you are considering exiting your business in the next five to seven years and would like to discuss a business valuation, contact an Adams Brown advisor.