Valuation for M&A E-Book

Chris M. Mellen

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 626

Veröffentlichungsjahr: 2010

Beschreibung

Discover the tools necessary to determine what your company'svalue is, what drives its value, and how to enhance that valueduring an M&A transaction. The only book to focus on valuation specifically for mergers andacquisitions, Valuation For M&A: Building Value in PrivateCompanies, Second Edition lays out the steps for measuring andmanaging value creation in privately held businesses. Thisgroundbreaking work led directly to authors Chris M. Mellen andFranck C. Evans being named the joint 2010 AM&AA Middle MarketThought Leader of the Year by the Alliance of Merger &Acquisition Advisors, and its thorough overview of the subject: * Recognizes a company as an investment and explains how tomanage that value to maximize shareholder returns, focusing onreturns, risks, and capital invested * Explains investment or strategic value versus fair marketvalue and provides a document request checklist; sample interviewquestions; and formats for adjusting financial statements,developing discount rates, the computation of net cash flow; and avaluation reconciliation form * Includes a comprehensive case study to illustrate concepts andcalculations * Now covers fair value accounting and the impact of SFAS Nos.141, 142, and 157 and their IFRS counterparts, intangible assetvaluation techniques, exit planning, international M&As, andventure backed/early stage companies Showing corporate executives as well as M&A professionalsand business appraisers how to value privately-held businesses formerger and acquisition purposes, this book helps investors,executives, and their advisors determine the optimum strategy toenhance both market value and strategic value to maximize return oninvestment.

Leseprobe

Table of Contents

Title Page

Copyright Page

Preface

Acknowledgements

CHAPTER 1 - Winning through Merger and Acquisition

Critical Values Shareholders Overlook

Stand-alone Fair Market Value

Investment Value to Strategic Buyers

“Win-Win” Benefits of Merger and Acquisition

CHAPTER 2 - Building Value and Measuring Return on Investment in a Private Company

Public Company Value Creation Model

Computing Private Company Value Creation and ROI

Analyzing Value Creation Strategies

CHAPTER 3 - Competitive Analysis

Linking Strategic Planning to Building Value

Assessing Specific-Company Risk

Competitive Factors Frequently Encountered in Nonpublic Entities

Financial Analysis

Conclusion

CHAPTER 4 - Merger and Acquisition Market and Planning Process

Common Seller and Buyer Motivations

Why Mergers and Acquisitions Fail

Sales Strategy and Process

Acquisition Strategy and Process

Due Diligence Preparation

CHAPTER 5 - Measuring Synergies

Synergy Measurement Process

Key Variables in Assessing Synergies

Synergy and Advance Planning

CHAPTER 6 - Exit Planning

Why Is Exit Planning So Difficult?

What Makes Planning for Your Private Company Investment Unique?

Why Should Exit Planning for Your Private Company Begin Now?

Exit Planning Process

Step 1: Setting Exit Goals

Step 2: Owner Readiness

Step 3: Type of Exiting Owner

Step 4: Exit Options

Step 5: Range of Values

Step 6: Execution of Exit Plan

CHAPTER 7 - Valuation Approaches and Fundamentals

Business Valuation Approaches

Using the Invested Capital Model to Define the Investment Being Appraised

Why Net Cash Flow Measures Value Most Accurately

Frequent Need to Negotiate from Earnings Measures

Financial Statement Adjustments

Managing Investment Risk in Merger and Acquisition

Conclusion

CHAPTER 8 - Income Approach: Using Rates and Returns to Establish Value

Why Values for Merger and Acquisition Should Be Driven by the Income Approach

Two Methods within the Income Approach

Three-Stage DCF Model

Establishing Defendable Long-term Growth Rates and Terminal Values

CHAPTER 9 - Cost of Capital Essentials for Accurate Valuations

Cost of Debt Capital

Cost of Preferred Stock

Cost of Common Stock

Fundamentals and Limitations of the Capital Asset Pricing Model

Modified Capital Asset Pricing Model

Build-up Model

Summary of Ibbotson Rate of Return Data

Private Cost of Capital

International Cost of Capital

How to Develop an Equity Cost for a Target Company

CHAPTER 10 - Weighted Average Cost of Capital

Iterative Weighted Average Cost of Capital Process

Shortcut Weighted Average Cost of Capital Formula

Common Errors in Computing Cost of Capital

CHAPTER 11 - Market Approach: Using Guideline Companies and Strategic Transactions

Merger and Acquisition Transactional Data Method

Guideline Public Company Method

Selection of Valuation Multiples

Market Multiples Commonly Used

CHAPTER 12 - Asset Approach

Book Value versus Market Value

Premises of Value

Use of the Asset Approach to Value Lack-of-Control Interests

Adjusted Book Value Method

Treatment of Nonoperating Assets or Asset Surpluses or Shortages

Specific Steps in Computing Adjusted Book Value

CHAPTER 13 - Adjusting Value through Premiums and Discounts

Applicability of Premiums and Discounts

Application and Derivation of Premiums and Discounts

Apply Discretion in the Size of the Adjustment

Control versus Lack of Control in Income-driven Methods

Fair Market Value versus Investment Value

CHAPTER 14 - Reconciling Initial Value Estimates and Determining Value Conclusion

Essential Need for Broad Perspective

Income Approach Review

Market Approach Review

Asset Approach Review

Value Reconciliation and Conclusion

Checks to Value

Candidly Assess Valuation Capabilities

CHAPTER 15 - Art of the Deal

Unique Negotiation Challenges

Deal Structure: Stock versus Assets

Terms of Sale: Cash versus Stock

Bridging the Gap

See the Deal from the Other Side

CHAPTER 16 - M&A and Financial Reporting

U.S. GAAP and IFRS

Relevant FASB and IFRS Statements

Reviews by the Audit Firm

ASC 820: Fair Value Measurements (SFAS 157)

ASC 805: Business Combinations (SFAS 141 (R) )

ASC 350: Goodwill and Other Intangible Assets (SFAS 142)

Incorporating ASC 805 (SFAS 141 (R)) into the Due Diligence Process

References

CHAPTER 17 - Intangible Asset Valuation

Approaches to Valuing Intangible Assets

Key Components to Intangible Asset Valuation

Intangible Asset Valuation Methods

Conclusion

CHAPTER 18 - Measuring and Managing Value in High-Tech Start-ups

Why Appraisals of High-Tech Start-ups Are Essential

Key Differences in High-Tech Start-ups

Value Management Begins with Competitive Analysis

Stages of Development

Risk and Discount Rates

Start-ups and Traditional Valuation Methods

QED Survey of Valuation Methods Used by Venture Capitalists

A Probability-Weighted Scenario Method to Value Start-ups

Equity Allocation Methods

Conclusion

CHAPTER 19 - Cross-Border M&A

Strategic Buy-Side Considerations

Due Diligence

Sell-Side Considerations

CHAPTER 20 - Merger and Acquisition Valuation Case Study

History and Competitive Conditions

Potential Buyers

General Economic Conditions

Specific Industry Conditions

Growth

Computation of the Stand-alone Fair Market Value

Computation of Investment Value

Suggested Considerations to Case Conclusion

About the Authors

Index

Copyright © 2010 by Chris M. Mellen and Frank C. Evans. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data

Mellen, Chris M.

Valuation for M&A: building value in private companies/Chris M. Mellen,

p. cm.

Includes index.

ISBN 978-0-470-60441-0 (cloth)

1. Corporations—Valuation. 2. Consolidation and merger of corporations. I. Evans, Frank C. II. Title. III. Title: Valuation for M & A. IV. Title: Valuation for M and A.

HG4028.V3E93 2010

658.16′ 2—dc22

2010004440

Preface

“Value” is an expression of the worth of something, measured using two metrics: return and rate of return. To create and build value, businesses must pursue strategies that raise the return, reduce the risk, or combine the two. Conceptually, this seems obvious, but application is more difficult.

The mystery surrounding a company’s value often causes executives to make bad investment and operational decisions. But these poor choices can be avoided. Accurate valuations are possible, and M&A deals can succeed for both buyers and sellers. The keys to success are in the pages that follow.

Through providing valuation advisory services to thousands of companies and corporate executives, we have developed the tools to accurately measure and successfully build value in companies. By employing these techniques, owners and managers can determine their company’s value, what drives it, and how to enhance that value both in M&A and through daily operations.

In M&A transactions, sellers, buyers, and even their advisors struggle over the value of a business. Often they are frustrated by what they see as the other side’s unrealistic expectations. These uncertainties abound:

• Do profits, often computed as EBIT or EBITDA, represent the company’s true return to shareholders?

• Is the forecasted performance realistic?

• What is an appropriate rate of return or multiple, considering the investment’s risk?

• Should the transaction be structured as an asset or stock deal?

• Has the seller properly prepared and packaged the company to get the best price?

• What personal issues are of critical importance to the seller?

• Has the buyer found the best target and accurately quantified potential synergies?

• Does the deal make sense at the quoted price?

Greater fundamental mystery exists in private companies—those not traded on a public stock market, including thinly traded public companies or divisions of large corporations. Most owners and managers operate these companies year after year without ever knowing the answers to these basic questions:

• What is the company worth?

• How much more would a strategic buyer pay to acquire it?

• What factors most affect the company’s stock value?

• What is the owners’ real return on investment and rate of return?

• Does that return justify the risk?

• Are owners better off selling, and if so, how and when?

Selling is just one of many options available to a business owner to exit the business. This second edition takes a step back to introduce the growing field of exit planning, explain the unique challenges of private company owner exit decisions and the exit planning process, and discuss some exit alternatives in cases where selling may not currently be the right option for the business owner.

• What financial, nonfinancial, professional, and personal issues must an owner consider in evaluating whether to exit, and, if so, how?

• What exit options other than a sale are available to the business owner?

• What makes planning a private company investment different?

• Why should exit planning for a private company begin now?

There have been considerable changes in the economy since the first edition was written. The economy has increasingly become more knowledge based, where intangible assets are a progressively more significant portion of a company’s value, and more global. Financial reporting standards pertaining to M&A transactions are responding—and this second edition has responded.

• What are the unique characteristics of foreign companies to consider in cross-border M&A?

• What are some of the key intangible assets owned by companies, and how are they valued?

• What are the important financial reporting considerations that must be addressed when completing a transaction?

• What are the unique challenges of measuring and managing value in high-tech start-ups to maximize shareholder value?

This book provides the tools to answer these and related questions. It is written for business owners, investors, and managers of companies who lack the guidance of a stock price set by a free and active market. Our solutions to valuation and return on investment questions create accountability and discipline in the M&A process. Our techniques incorporate value enhancement into a private company’s annual strategic planning to provide direction to shareholders in their investment decisions. In short, our book is a road map to building value in both operating a company and selling or buying one.

Many investors have heard about building value in a public company where the stock price provides the market’s reaction to the company’s performance. It is much more difficult to develop a successful strategy and measure performance and ROI accurately when no stock price exists. Difficult, but not impossible.

We invite our readers to employ these techniques to achieve accurate M&A valuations and to build value in daily operations. Trade the mystery for this road map to wealth.

Chris M. Mellen Frank C. Evans May 2010

Dedication and Acknowledgments

This book is dedicated to our dear friend and mentor, David Bishop, coauthor of the first edition. Through his formation of the American Business Appraisers national network, David brought us together and provided countless hours of education and guidance to elevate us in the business valuation profession. For that we are deeply grateful.

In addition to David, this book would not have been completed successfully without the help and support of many of our colleagues and of Sheck Cho at John Wiley & Sons. We would also like to thank Sid Shaver for his contribution of Chapter 19, “Cross-Border M&A.”

My thanks to exit planning advisor extraordinaire John Leonetti for his invaluable feedback and many suggestions on the exit planning chapter. I would also like to thank Ray Rath, René Hlousek, and Darren Cordier for their edits and feedback on the financial reporting and intangible asset chapters; and Frank Mainville for his critique and enhancements to the high-tech start-up chapter. I would like to also express my appreciation to the Delphi Valuation Advisors team for their research, comments, and support. And, most important, I owe my deepest gratitude to my family. To my wife, Kim, and my daughters, Sophia and Julia, thank you for your tolerance of my long hours while I was working on this book; and for the love, light, and support you bring to me every day!

Chris Mellen

My continuing thanks to my brother, Harry Evans, who helped so much with the first edition; to my friend and colleague Frank Mindicino, for his unique knowledge and insights; and to my assistant, Shelly Myers, and my partner and daughter, Sarah DeKreek. Finally, to my wife, Lin, thanks for your love and support in so many ways.

Frank Evans

CHAPTER 1

Winning through Merger and Acquisition

Buyers and sellers can create substantial value through merger and acquisition (M&A). Both can win from a transaction. That is the beauty of deal making. And that is much of the allure that has driven the tremendous volume of M&A activity worldwide over the last two decades.1 Despite this volume, most businesses are not salable. M&A advisors disqualify roughly 65% to 75% of prospective sellers and, according to a U.S. Chamber of Commerce Study, only 20% of the businesses that are for sale will successfully transfer hands to another owner. This implies that only 5% to 7% of companies actually get sold.

This book focuses on business value—what creates it, how to measure it, how to build it, how to preserve it, and how to maximize it through a transaction. It is this focus that will improve the chances of selling a business. These concepts are equally important to buyers and sellers because both can and should benefit from a deal. But different results frequently occur. Sellers may sell under adverse conditions or accept too low a price due to lack of preparation or knowledge. And every buyer runs the risk of purchasing the wrong business or paying too much. As seen during the Great Recession that began in December 2007, transactions during adverse economic times create their own sets of challenges. That is why understanding value—and what drives it—is critical in mergers and acquisitions.

Wise shareholders and managers do not, however, confine their focus on value to only M&A. Value creation drives their strategic planning and, in the process, creates focus and direction for their company. Their M&A strategy supports and complements their broader goal of building shareholder value, and they buy and sell only when the deal creates value for them.

This brings us back to the purpose of this book. It explains how to create, measure, build, preserve, and maximize value in mergers and acquisitions in the context of the broader business goal of building value. Senior managers in most public companies focus on value every day because it is reflected in the movement of their stock price—the daily scorecard of their performance relative to other investment choices. Private companies, however, lack this market feedback and direction. Their shareholders and executives seldom understand what their company is worth or clearly see what drives its value. For this reason, many private companies—and business segments of public companies as well—lack direction and under-perform.

Managing the value of a private company, or a division of a public corporation, is particularly difficult because that value is harder to compute and justify. Yet most business activity—and value creation or destruction—occurs at this operational level.

Being able to accurately measure and manage the value of smaller businesses or business segments is critical in the value creation process. And this skill will pay off in M&A as well because most transactions involve smaller entities. Although we read and hear about the big deals that involve large corporations with known stock prices, the median M&A transaction size in the United States between 2004 and 2008 was approximately $29 million. Smaller deals involving closely held companies or segments of public companies are the scene for most M&A activity.

Therefore, every value-minded shareholder and executive must strive to maximize value at this smaller-entity level where daily stock prices do not exist. The concepts and techniques that follow explain how to measure and manage value on a daily basis and particularly in M&A. The discussion begins with an understanding of what value is.

Critical Values Shareholders Overlook

When buyers see a potential target, their analysis frequently begins by identifying and quantifying the synergies they could achieve through the acquisition. They prepare a model that forecasts the target’s potential revenues if they owned it, the adjusted expense levels under their management, and the resulting income or cash flow that they anticipate. They then discount these future returns by their company’s cost of capital to determine the target’s value to them. Armed with this estimate of value, they begin negotiations aimed at a deal that is intended to create value.

If the target is not a public company with a known stock price, frequently no one even asks what the target is worth to its present owners. However, the value the business creates for the present owners is all that they really have to sell. Most, and sometimes all, of the potential synergies in the deal are created by the buyer, rather than the seller, so the buyer should not have to pay the seller for the value the buyer creates. But in the scenario just described, the buyer is likely to do so because his or her company does not know what the target is worth as a stand-alone business. Consequently, the buyer also does not know what the synergies created by his or her company through the acquisition are worth, or what the company’s initial offer should be.

Sellers are frequently as uninformed or misinformed as buyers. Many times the owners of the target do not know if they should sell, how to find potential buyers, which buyers can afford to pay the most to acquire them, what they could do to maximize their sale value, or how to go about the sale process. After all, many sellers are involved in only one such transaction in their career. They seldom know what their company is currently worth as a stand-alone business, what value drivers or risk drivers most influence its value, or how much more, if any, it would be worth to a strategic buyer. Typically none of their team of traditional advisors—their controller, outside accountant, banker, or attorney—is an expert in business valuation. Few of these professionals understand what drives business value or the subtle distinction between the value of a company as a stand-alone business versus what it could be worth in the hands of a strategic buyer.

The seller could seek advice from an intermediary, most commonly an investment banker or business broker. But these advisors typically are paid a commission—if and only if they achieve a sale. Perhaps current owners could achieve a higher return by improving the business to position it to achieve a greater value before selling. This advice is seldom popular with intermediaries because it postpones or eliminates their commission.

With sound advice so hard to find, sellers frequently postpone sale considerations. Delay is often the easier emotional choice for many entrepreneurs who identify personally with their company. But with delay, opportunities are frequently lost. External factors, including economic, industry, and competitive conditions that may dramatically affect value, can change quickly. Consolidation trends, technological innovations, or regulatory and tax reforms also can expand or contract M&A opportunities and value.

Procrastination also can hamper estate planning and tax strategies because delays reduce options. And the bad consequences are particularly acute when value is rapidly increasing.

Thus, buyers and sellers have very strong incentives to understand value, manage what drives it, and track it to their mutual benefit.

Stand-alone Fair Market Value

With a proper focus on maximizing shareholder value, buyers and sellers begin by computing the target company’s stand-alone fair market value, the worth of what the sellers currently own. This value reflects the company’s size, access to capital, depth and breadth of products and services, quality of management, market share and customer base, levels of liquidity and financial leverage, and overall profitability and cash flow as a stand-alone business.

With these characteristics in mind, “fair market value” is defined by Revenue Ruling 59-60 of the Internal Revenue Service as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”

Fair market value includes these assumptions:

• Buyers and sellers are hypothetical, typical of the market, and acting in their own self-interest.

• The hypothetical buyer is prudent but without synergistic benefit.

• The business will continue as a going concern and not be liquidated.

• The hypothetical sale will be for cash.

• The parties are able as well as willing.

• The hypothetical seller is not forced to sell (i.e., accept an offer that represents a “distress sale”) and a buyer is not compelled to buy (i.e., necessary to earn a living).

• The reference is to “price” rather than “proceeds.”

• The parties operate at arm’s length, or independent of each other.

• Both parties have reasonable knowledge of the relevant facts.

• The seller must be willing to accept the price available under prevailing economic, industry, and market conditions as of the effective date.

The buyer under fair market value is considered to be a “financial” and not a “strategic” buyer. The buyer contributes only capital and management of equivalent competence to that of the current management. This excludes the buyer who, because of other business activities, brings some “valueadded” benefits to the company that will enhance the company being valued and/or the buyer’s other business activities (e.g., being acquired by other companies in the same or a similar industry). Also excluded is the buyer who is already a shareholder, creditor, or related or controlled entity who might be willing to acquire the interest at an artificially high or low price due to considerations not typical of the motivation of the arm’s-length financial buyer.

The seller in the fair market value process is also hypothetical and possesses knowledge of the relevant facts, including the influences on value exerted by the market, the company’s risk and value drivers, and the degree of control and lack of marketability of that specific interest in the business.

While fair market value is impersonal in nature, “investment value” reflects the value to a particular buyer based on that buyer’s circumstances and investment requirements. This value includes the synergies or other advantages the strategic buyer anticipates will be created through the acquisition.

Fair market value should represent the minimum price that a financially motivated seller would accept because the seller, as the owner of the business, currently enjoys the benefits this value provides. The controlling shareholder in a privately held company frequently possesses substantial liquidity because he or she can harvest the cash flow the company generates or sell the company. The lack-of-control or minority shareholder generally possesses far less liquidity. As a result, the value of a lack-of-control interest is usually substantially less than that interest’s proportionate ownership in the value of the business on a control basis.

Prospective buyers who have computed stand-alone fair market value should also recognize that this is the base value from which their negotiating position should begin. The maximum value the buyer expects to create from the deal is the excess of investment value over fair market value. So any premium the buyer pays above fair market value reduces the buyer’s potential gain because the seller receives this portion of the value created.

As discussed further in Chapter 6, sellers frequently are motivated by nonfinancial considerations, such as their desire to pass ownership of the company on to their children or long-term qualified employees, or, if they work in the company, to retire or do something else. When these nonfinancial considerations exist, it is particularly important for shareholders to understand the financial effect of decisions made for personal reasons. Opportunistic buyers can take advantage of sellers, particularly those who are in adverse personal circumstances. Once again, this fact stresses the need for a continual focus on value and implementation of a strategic planning process that routinely considers sale of the company as a viable option to maximize shareholder value. This process accommodates shareholders’ nonfinancial goals and provides the time and structure to achieve them and manage value as well.

Investment Value to Strategic Buyers

The investment value of a target is its value to a specific strategic buyer, recognizing that buyer’s attributes and the synergies and other integrative benefits that can be achieved through the acquisition. Also known as strategic value, the target’s investment value is probably different to each potential buyer because of the different synergies that each can create through the acquisition. For example, one buyer may have a distribution system, product line, or sales territory in which the target would fit better than with any other potential buyer. Generally this is the company to which the target is worth the most. Well-informed buyers and sellers determine these strategic advantages in advance and negotiate with this knowledge.

EXHIBIT 1.1 Fair Market Value versus Investment Value

Investment Value - 2____________Investment Value - 1____________Acquisition PremiumFair Market Value___________

The difference between fair market value and investment value is portrayed in Exhibit 1.1, which shows an investment value for two potential buyers. The increase in investment value over the company’s fair market value is most commonly referred to as a control premium, but this term is somewhat misleading. Although the typical buyer does acquire control of the target through the acquisition, the premium paid is generally to achieve the synergies that the combination will create. Thus, this premium is more accurately referred to as an acquisition premium because the primary force driving it is synergies, rather than control, which is only the authority necessary to activate the synergy.

The obvious questions this discussion generates are:

• Why should a buyer pay more than fair market value?

• If the buyer must pay an acquisition premium to make the acquisition, how much above fair market value should the buyer pay (i.e., how large should the acquisition premium be, either as a dollar amount or as a percentage of fair market value)?

The mean and median acquisition premiums for purchases of public companies in the United States have been about 40% and 30%, respectively, over the last 10 years. These figures are not presented as a guideline or as a target. Premiums paid are based on competitive factors, consolidation trends, economies of scale, and buyer and seller motivations—facts that again emphasize the need to thoroughly understand value and industry trends before negotiations begin. For example, a company with a fair market value of $10 million has a much stronger bargaining position if its maximum investment value is $20 million than if it is only $12 million. To negotiate the best possible price, however, the seller should attempt to determine what its maximum investment value is, which potential buyer may have the capacity to pay the most in an acquisition, and what alternatives each buyer has, and then negotiate accordingly.

Generally speaking, buyers should begin their negotiations based on fair market value. Before they enter the negotiation process, where emotional factors and the desire to “do the deal” take over, buyers should establish their walk-away price. This is the maximum amount above fair market value that they are willing to pay to make the acquisition. Establishing the maximum price in advance encourages buyers to focus on value rather than on “winning” the deal. Naturally, the farther the price moves above fair market value toward that buyer’s investment value, the less attractive the deal becomes. Value-oriented buyers recognize that acquisitions at a price close to their investment value require them to fully achieve almost all forecasted synergies—on time—to achieve the forecasted value. And the closer the acquisition price gets to their investment value, the less value the acquisition can create for the buyer’s shareholders and the smaller the buyer’s potential margin of error. When a seller demands too high a price, the buyer’s better option is often to decline that deal and look for one with a better potential to create value.

This fact illustrates a fundamental but essential lesson in making any investment: Identify the distinction between a good company and a good investment. While a good company may possess many strengths, it will prove to be a bad investment if the price paid for it is too high. Conversely, a company with weaknesses may offer a good investment opportunity if the price is adequately low relative to the forecasted returns, particularly to the strategic buyer who possesses the strengths to compensate for the target’s weaknesses.

“Win-Win” Benefits of Merger and Acquisition

To illustrate the “win-win” benefits of M&A to buyers and sellers, the next discussion summarizes the valuation of Cavendish Seafood Distributors, which is presented in detail in Chapter 20. Many of the technical steps in this illustration are explained only briefly. Each step is described in detail in the chapters that follow. Various technical issues will be introduced in italicized print with a reference to the chapter that explains how to handle these matters.

Cavendish was founded about 20 years ago by Lou Bertin, who had enjoyed a successful career as a restaurateur. Bertin, who had an MBA and always wanted to run his own business but was tired of the demands of running a restaurant, recognized a need for better distribution of seafood to restaurants in his home state. Armed with his entrepreneurial spirit, substantial expertise in running restaurants, $1.7 million of his and two 10% minority investors’ equity cash, and a well-conceived business plan, he founded Cavendish.

As with most small companies, however, several major risks and constraints weighed heavily on Bertin. He is looking to retire or at least reduce his hours. And although Cavendish is successful, Bertin has seen his personal wealth increasingly tied to the fate of the company at a time in his life when he knows diversification is the much wiser investment strategy. Should Bertin’s 80% equity interest in Cavendish be valued, or some other investment? Would the valuation process or computation be different if he owned a 100% interest and there were no minority shareholders, or if all of the stock were owned by minority shareholders? (See Chapters 6 and 13.)

Sales for Cavendish’s latest year top $75 million, and earnings before interest and taxes (EBIT) adjusted to reflect ongoing operations will be about $7.5 million. Is EBIT the best measure of return for Cavendish? Would it be more accurate to use revenue or net income before or after taxes or cash flow? (See Chapter 7.) Cavendish is heavily leveraged. To move toward long-term stability, significant additional capital spending is required. Does the financial leverage affect value, and if so, how? (See Chapter 10.) Does the anticipated capital spending affect value, and if so, how do we account for it? (See Chapter 7.)

The company’s product line is narrow by industry standards, although it has developed a loyal and rapidly growing base of restaurants and grocery stores. Cavendish’s profit margins were significantly impacted by the spike in fuel prices in 2008 followed by the drop in demand from restaurants due to the recession that ensued. How can the valuation reflect these various risk drivers and value drivers? What if the buyer can eliminate some of these weaknesses? (See Chapters 3 and 9.) Bertin’s staff is comprised primarily of family members and people like him who had burned out of working in restaurants and were looking for a career switch to an industry with “normal” working hours. Bertin himself has lost the enthusiasm for the strategic planning the company would need to continue its historical growth performance. Should an adjustment be made if some of these individuals do not materially contribute to the success of the company? Should an adjustment be made if anyone is paid above- or below-market compensation? (See Chapter 7.)

Bertin has been routinely approached by business brokers and contacts within the food distribution industry about a sale of the company, and he is especially concerned by the volatile economic conditions over the past couple of years. In addition, one of Cavendish’s major competitors, a company that is five times the size of Cavendish, is using its leverage to push Cavendish out of some of the urban markets in Cavendish’s core territory. This more intense competition, coupled with the economic conditions, has led Bertin to postpone planned price increases. Can these competitive issues be identified by reviewing Cavendish’s financial statements? What additional research, if any, is required? How are these competitive factors reflected in the valuation? (See Chapters 3 and 9.)

Computation of Cavendish’s Stand-alone, Fair Market Value

As a small- to middle-market-size company, Cavendish carries many risks, including limited capital, high financial leverage, a narrow product line, and very limited management. When combined with the company’s loyal customer base, rapid sales growth, high product quality, and average profitability, these factors generate Cavendish’s weighted average cost of capital rate of 18%, which reflects its risk profile and growth prospects.

Is a weighted average cost of capital the same as a discount rate? Is this the same as a capitalization rate? (See Chapters 8 and 10.) When the company’s normalized net income to invested capital of $4.8 million for this year is divided by a 14% weighted average cost of capital (WACC) capitalization rate, the fair market value on a stand-alone basis of the enterprise is determined to be $35.7 million. Is this the value of equity? (See Chapter 7). Why is only one year of earnings used to compute value? How does this reflect future year growth? (See Chapter 8.)

Investment Value to Strategic Buyer

A larger public company that wants to quickly acquire a presence in Cavendish’s market recognizes its strengths and weaknesses. Because the larger buyer frequently can eliminate many of Cavendish’s limitations, it can increase Cavendish’s sales growth and profits much more rapidly. Cavendish is also much less risky as a segment of the large company that possesses a broad array of market strengths. How are these changes in risk reflected in the valuation? Who gets this value? (See Chapter 3.)

When owned by the strategic buyer, Cavendish’s stand-alone EBIT could be increased over the next several years through more efficient operations and access to a broader market and an extensive distribution system. In the terminal period following the forecast, Cavendish’s growth should be similar to that consistent with expectations for the food distribution industry. How should the forecast and the years thereafter be used in computing value? (See Chapter 8.)

After the deal is closed, the buyer will have to allocate the purchase price for financial reporting purposes. Part of this process will involve identifying and valuing Cavendish’s intangible assets. What financial reporting considerations will have to be made? (See Chapter 16.) What are the intangible assets owned by Cavendish, and how are they valued? (See Chapters 16 and 17.)

While Cavendish has a WACC capitalization rate of 14%, Omni Distributors, the buyer, a large, well-known public company, has a WACC discount rate of about 12%. How are cap rates and discount rates different, and when should each be used? (See Chapters 8 through 10.) Because Cavendish operates in a new market for this buyer, has limited management and increasing competition, the buyer adjusted its discount rate for the added risk of Cavendish. Should the buyer use its own discount rate to compute the investment value of Cavendish? If not, how should it be adjusted? How should this rate be affected by Cavendish’s high financial leverage? (See Chapter 10.) The multiple-period discounting of Cavendish’s forecasted net cash flow to invested capital adjusted for synergies determined that Cavendish’s invested capital is worth $51.7 million to one strategic buyer. What is net cash flow to invested capital, how is it computed, and how many years should be discretely forecasted? (See Chapter 7.) How does this discounting process reflect the potential adjustments to the return and the rate of return for the risk drivers and value drivers that have been considered? (See Chapters 8 and 9.) The $15 million excess of the $51.7 million investment value of invested capital over Cavendish’s $35.4 million fair market value means this buyer could pay up to $15.3 million over stand-alone fair market value to acquire Cavendish. What should be the minimum value considered by both the buyer and the seller to start the negotiations? How much above $35.4 million should this buyer be willing to pay to acquire Cavendish? Should this decision be influenced by competitors also bidding to acquire Cavendish? If the buyer ultimately pays $51.7 million to acquire Cavendish, is the buyer better off? How? (See Chapters 1, 4, and 5.)

Cavendish’s balance sheet shows assets of almost $44 million and equity of $15 million. How do these affect its value? (See Chapters 12 and 13.) Public companies in Cavendish’s industry are selling at EBIT multiples ranging from 3 to 18, with a mean of 8. Should these be considered, and how? Do the EBIT multiples generate equity value? (See Chapter 11.) Another public food distributor recently sold for a 72% premium over its market value. Should this transaction be considered in determining value? (See Chapter 11.)

Since Cavendish is not a public company, should there be a discount for lack of marketability? Since Cavendish has minority owners, is a control premium or discount for lack of control needed? (See Chapter 13.)

Can a buyer employ strategies to reduce risk in an acquisition? (See Chapters 4 and 17.) How can buyers most effectively evaluate synergies? (See Chapter 5).

Can sellers employ a strategy to build value? Can they effectively plan in advance for a sale? (See Chapters 2 and 4.)

Buyers and sellers clearly have opportunities to gain through mergers and acquisitions. In order to create value, however, they must be able to measure and manage it. This process begins with the ability to identify and quantify those factors that create value. Most often, this must be done in a privately held company or a division of a public corporation where stock prices do not exist. The chapters to come explain how to build operating value in a private company and how to create, measure, and manage value in mergers and acquisitions.

CHAPTER 2

Building Value and Measuring Return on Investment in a Private Company

So much as been written about “value” and “creating value” that these concepts have acquired many meanings. Buyers and sellers must recognize how strategies affect value to achieve maximum benefit from purchase or sale decisions. It is even more important for owners and executives to understand how value is created or destroyed as they manage their daily operations where no immediate sale is anticipated. To manage value creation effectively in closely held companies, segments of public companies, and thinly traded public companies, that value must first be measured. Doing so requires precision in the definition and measurement of “investment,” “return,” “rate of return,” and “value” to accurately compute value and return on investment. Yet each of these metrics is almost always measured and reported incorrectly for nonpublic entities. As a result, their true economic performance and any resulting value creation or destruction is unknown, and investors seldom ever even know that they are misinformed.