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Valuation of the Business 31
key managers to cut great deals for themselves with the Buyer. If their
employment agreements are conditions to closing, they can potentially
unilaterally blow up the closing by requiring deals that the Buyer will
not agree to. If a deal on employment terms is not struck, one of the
conditions to the Buyer’s obligation to close will have failed. In my
view, the preferred course is to negotiate all of these agreements after
the basic points of the deal have been agreed and before the signing of
the definitive agreement, and have the signing of the employment and
noncompete agreements occur simultaneously with the signing of the
acquisition agreement, with the employee agreements to be effective
upon the closing under the acquisition agreement.
The definitive acquisition agreement is discussed in more detail
in Chapter 5.
VALUATION OF THE BUSINESS
We have discussed the role of the investment banker in M&A trans-
actions. One of the first things that an investment banker will do is
to give the client or prospective client an estimate of what the bank
thinks the business will be sold for. It is not a good idea for any of
the participants to start down the sale path if the Target’s expectations
bear no relation to reality.
One pitfall is that investment bankers use financial jargon that
may create a misunderstanding with the client. For one, bankers use
the concepts of enterprise value and equity value. Enterprise value
means what a Buyer would effectively have to pay to own all of the
claims on the business, including debt, or sometimes debt less cash
on hand. Another way of looking at this is that Buyers almost always
pay off the Target’s debt at closing, either because the debt acceler-
ates (becomes due) on a change of control or because the Buyer has
a different financing strategy. Equity value means the value of the
stock of the company. If a bank tells the client that it thinks the enter-
prise value of the business is X dollars, make sure that the parties are
speaking the same language, particularly if the Target has significant
indebtedness.
Ironically, bankers disregard much of the fancy valuation theory
explored in Chapter 1. For academic purposes, it is nice to throw
around concepts like the present value of all future cash flows of the
business as being its intrinsic value. But go try to calculate that.
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32 Ch. 2 The Acquisition Process
Bankers take a much more practical and multifaceted approach.
Because there is a lot of subjectivity in all of the valuation method-
ologies, bankers usually express value as a range, meaning that fair
market value is somewhere between the minimum value a seller is
willing to accept and the maximum value a buyer is willing to pay.
Fair market value is the range in which informed and willing buyers
and sellers would buy/sell the business.
For private companies, the valuation process is more difficult.
There is no reference public market trading price. The business may
or may not have audited financial statements. In addition, private com-
panies often play games for tax purposes. There may be excess com-
pensation to reduce income and therefore avoid double tax; business
expenses and personal expenses may not be properly differentiated;
and the business generally may be run without net profit maximiza-
tion as a primary goal. The bank, therefore, may have to normalize
the financial prospects of the business to better reflect the performance
that the Buyer should expect.
Normalization may include adjustments other than to correct
for off-market compensation and expenses. Financial statements pre-
pared in accordance with generally accepted accounting principles
(GAAP) use rigorous principles to try to do their own normaliza-
tion of period-to-period revenue and expense. For example, financial
statements continue to reflect expenses associated with discontinued
operations after they have been discontinued and are therefore of no
interest to the Buyer. In addition, if the Target’s and the Buyer’s opera-
tions are to be consolidated, overlapping expenses must be eliminated.
So-called nonrecurring extraordinary items may also be eliminated.
All valuation methodologies assume that the value of a company
is based solely on the financial benefits it provides to its owners, either
what they would receive on liquidation or what the going-concern value
would be. Going-concern value is the value of the business, from a
financial point of view, as an ongoing generator of cash.
The principal valuation methodologies used by bankers are:
• Relative valuation. The business is valued based on the observ-
able market value of comparable properties—comparable
meaning of similar size, having similar products and a sim-
ilar risk profile. Financial measures are derived from the
comparable properties, so relative value examines ratios like
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Valuation of the Business 33
price-to-earnings or price-to-revenue of comparable businesses
and applies those metrics to the Target’s business.
• Discounted cash flow valuation. This methodology has its
parentage in the theoretical measures discussed in Chapter 1,
but cash flow is usually only projected out to five years or so
since beyond that the numbers are usually speculative.
RELATIVE VALUATION. Relative valuation applies valuation metrics
to comparable companies. A number of different valuation metrics
are used in this type of analysis. Commonly used non-GAAP metrics
include, in addition to net income, earnings before interest and taxes
(EBIT) and earnings before interest, taxes, depreciation, and amorti-
zation (EBITDA). Both EBIT and EBITDA represent departures from
GAAP that may better reflect what the Buyer will really look at in
doing its own analysis, usually cash flow. Interest and taxes may be
excluded because the Buyer may not need to use debt to capitalize
the business and/or may have a different tax status than the Target.
For example, the Buyer may have net operating loss carryforwards
that will shelter future income. Depreciation and amortization may be
excluded because they are noncash measures that the Buyer may think
are not relevant at least to its short- or medium-term running of the
business—the key capital equipment may not have to be replaced for
many years.
Also, it should be noted generally, GAAP is based on the twin
principles of conservatism and historical cost. Non-GAAP measures are
used to extract out or modify items that are based on these principles
where Buyers may think them to be irrelevant for their purposes. For
example, a business’s depreciation expense may not reflect the current
purchase price of necessary assets.
In some cases, even these adjusted measures are irrelevant. An
example is an Internet business that is just being started and has little
or no revenue. Because the business likely will have no imminent
earnings or EBIT, the Buyer will be expected to value the business
for its revenue growth potential. Another example is the purchase of a
product line rather than an entire business. In such cases, the closest
metric is enterprise value to revenue.
Another metric that may be relevant is growth rate. Rapid growth
may be predictive of future cash flow increases, and that must be
factored into relative valuation analysis.
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34 Ch. 2 The Acquisition Process
Valuation multiples are then derived once these base measures
are calculated and then compared to those of comparable companies:
• Enterprise value to EBITDA.
• Equity value to net income.
• Enterprise value to EBIT.
• Enterprise value to revenue.
• Equity value to book value of equity.
There are several discrete approaches in the relative valuation
methodology. One is comparable public company analysis , where a
peer group of publicly traded companies is examined. There is much
available data on public companies from their SEC filings, but it may
be difficult to find a comparable one given the limited universe of
public companies. Conceptually, when public company comparables
are used to value a private company, consideration must be given to
a so-called private company discount, meaning that on an individual
shareholder basis, privately held stock is inherently less valuable than
publicly traded securities. However, control is being sold when the
entire business of the Target is sold, so a premiums analysis must be
made that ratchets up the value of the company for what control would
be sold for. Once the public company comparables are identified, the
traditional financial ratios are compiled and compared to the company
being sold. Some are considered more relevant than others depending
on the nature of the business.
Another approach is comparable transaction analysis , where
recent sales transactions for comparable companies are examined and
financial metrics are compared.
DISCOUNTED CASH FLOW ANALYSIS. This resembles our theoreti-
cal intrinsic value analysis, with a couple of distinctions. The discount
rate is usually the Target’s cost of debt and equity capital, although it
is hard to understand why the Target’s cost of capital should be used
rather than the cost of capital of the Buyer (particularly if the expected
Buyer is a public company) or of a public company comparable to the
Target, or an average cost of capital for public companies generally.
The discounted cash flow analysis measures what the investment is
meant to return, considering the cost to finance it—but, again, the cost
to whom? The cost of equity capital is a somewhat ephemeral concept
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Investment Bank Engagement Letters 35
because of the wide variation in the so-called price of equity (.,
venture capital is considered to be extremely expensive because of the
risk involved in early stage investing).
Also, there is a lot of guesswork even in short-term projections,
so that theoretical projections out to infinity make no sense. The solu-
tion is to use several years’ worth of projections, often five, and to
assign a terminal value to the business as of the end of the projection
period based on relative valuation analysis. The projections are also
discounted for risk.
In sum, all of the valuation methodologies have only limited
usefulness because of the highly subjective nature of their elements.
They provide a rough estimate of a valuation range, and the data accu-
mulated is often used in the Buyer-Target price negotiation. What a
business is worth comes down to what a Buyer is willing to pay for
it. It is ultimately a matter of supply and demand, and so the process
by which demand is generated is extremely important. That is where
the investment banker fits in, as discussed earlier.
INVESTMENT BANK ENGAGEMENT LETTERS
Both Targets and Buyers frequently use the services of an investment
bank in M&A transactions. Although Targets are reluctant to pay the
related fees, most experienced Targets and their advisers believe that
in transactions of any substantial size, an investment bank adds net
value by locating potential Buyers, assisting in pricing the transaction,
assisting in negotiating the agreements, and bringing the transaction to
a successful conclusion. The principles of supply and demand would
suggest that generating interest results in better pricing. For public
companies involved in a transaction where the board is making a rec-
ommendation to the shareholders, receipt of a fairness opinion from an
investment bank is almost universal practice as a protective measure
for the board. These opinions are relatively rare in private acquisitions
and are obtained only if the transaction is controversial.
Selecting the investment banker is the first consideration. The
knee-jerk approach is that bigger or more famous is better. Although
the large investment banks generally do a highly professional job
in M&A engagements, the attention they devote to any particular
smaller engagement varies. If the transaction is significant in size or
