We were recently engaged to value a national retail company because the owner wants to groom it for sale. He had received a soft offer for his business about 6 years ago. Although he wasn’t ready to sell at the time, he feels he is now ready to develop an exit strategy and wants to sell his business for the highest gain possible.
For most small businesses, the pool of potential buyers consists primarily of someone who wants to take it over and run it as it is as a stand-alone business. We call these types of buyers “financial buyers.” Financial buyers look at the fair market value (FMV) of the business. Based on Internal Revenue Service Revenue Ruling 59-60, plus 50 years of tax court rulings, FMV is defined as “the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both having reasonable knowledge of relevant facts.”
In some cases, however, a business can have qualities and features that make it attractive to larger companies for various reasons. These qualities are called synergies. The premise of “synergistic” value (or investment value) is defined as the specific value of an investment to a particular investor (or class of investors) based on individual investment requirements and expectations. For the same company at the same valuation date, the differences between these two premises of value can produce significantly different conclusions of value.
The differences between a synergistic value and a FMV premise are quantified in the following four ways:
- Estimates of future earning power
- Perception of the degree of risk
- Financing costs and/or tax status
- Synergies with operations owned or controlled
Unlike the “financial buyer” identified above, most synergistic buyers do not intend to run the business as a stand-alone business. In fact, the “synergies” by their nature create a situation where the buyer will run the acquired business in conjunction with another business or division. The synergies generally come from the anticipated consolidated operations such as:
· General and administrative expenses
· Costs of goods sold (volume purchasing)
· Horizontal or vertical integration
· Lower financing costs
No matter what the reason, the degree to which the differences identified above are quantified and used in the ultimate value conclusion (or purchase price tendered) is in large part dependent upon the willingness of a particular buyer to share in the identified synergistic benefits and how much of those benefits they are willing to pass onto the seller as a premium. Therefore, a seller side analysis without a specific buyer in mind can only offer a potential range of value and serve as boundaries for reasonable negotiating discussion points with potential buyers.
The retail business we were engaged to value has been in business for 25 years with a strong reputation within the industry. The business has been well run and does better than the industry average of its peers. There is excess cash in the business and little debt, but revenue has been flat for three years. The company is ripe for an infusion of capital to target growth beyond its current geographic areas.
A valuation of this company using the FMV premise of value, produced a conclusion of value of close to $30 million. Based on the previous soft offer and the potential growth the owner feels is inherent in the business, he was thinking the company was worth more like $40 million.
Of the four areas listed above, where synergistic value can be found, the first two could be estimated without a specific buyer in mind; estimates of future earning power and the perception of the degree of risk. We can only assume there would be additional differences once specific areas for synergy are discovered when a particular buyer is identified.
After obtaining a new set of projections for the next five years based on growth multiples that management feels is possible (given additional capital for infrastructure and marketing), we applied the company’s proven profitability ratios and created a prospective look at the financial statements to create a discounted cash flow (DCF) model. To apply the DCF method of valuation properly, we also considered and analyzed the effect of growth rate, taxes, CapX and depreciation.
The second area we were able to estimate was the degree of risk to apply to the future cash flows. Our starting point was the risk attributable to the company in our FMV analysis. In this case, it was 17.6 percent. We then researched the applicable rates of the pool of potential acquirers in the industry and found the median market weighted average cost of capital using the build-up method is 10.6 percent. This is quite a difference. What it means is, a potential acquiring company from this pool of identified companies, has room to work in a “premium” to be paid to the seller by way of sharing some of the benefit of its lower risk rate in the deal.
Knowing these factors, we were able to calculate DCF models that demonstrate synergistic value scenarios for the company close to what the owner was hoping for. This range of values now becomes his “playing field” as he works to make the company an attractive target for a potential buyer.