Continuing the reflection on M&A (access part I here), in this new article we will cover the Valuation process, the most used techniques and the difference between company and shareholder value.
Once the initial reflection phase of the M&A process is over, where the entrepreneur must have a clear understanding of the purpose of the operation, the type of investor he wants to contact and the depth of the changes that the company and himself will need to go through, the time has come to form the team and, in fact, start the journey.
Although the company may try to conduct the entire M&A process with its own team, if it has a well-structured financial department and, in particular, the controllership, it is recommended that you seek specialized advice, especially if you are not familiar with this type of transaction. In this sense, the most usual advisory services are:
I. M&A advice – provided mainly by investment banks or M&A boutiques, it is normally hired at the beginning of the process to support the entrepreneur from the initial stage of discussion on the type of investor and the selection of potential targets, up to the closing of the transaction and the consequent entry of funds at the closing. They also actively participate:
i) in the preparation of materials that will be distributed to potential investors, such as: teaser, info memo, ebitda bridge, etc;
ii) in the valuation discussion;
iii) due diligence support, especially in the numerous Q&A sessions that are likely to be referred by the advisors hired by the potential investor;
iv) in the discussion of the investment contract and, if the transaction does not involve the sale of 100% of the participation, in the shareholders’ agreement.
II. Legal advice – essential in the discussion and formatting of the investment contract and the shareholders’ agreement, especially in the definition of deadlock provision clauses. It also assumes a relevant role in conducting the process with the Administrative Council for Economic Defense – CADE.
Prospecting Potential Investors
After forming the team and choosing the target company (ies) based on the initial considerations, the operation advisor will prepare the teaser – material with basic information about the company. Investors really interested in evaluating the deal, and after signing the NDA (Non Disclosure Agreement), the Info Memo (IM) is provided – a complete package of company information and its operation. The info memo must contain a detailed description, comprehensive and accurate analysis of the company and the industry in which it operates, in order to provide sufficient subsidies for the potential investor to evaluate it and, subsequently, to present a preferably binding proposal, subject only to confirmatory due diligence.
At this stage, the entrepreneur must already have an idea of the company’s value, normally obtained through a Valuation.
Valuation
Valuation is the term that refers to the process of calculating the value of individual assets, jointly, or constituted in the form of a company, whether they are real or financial.
There are several approaches that can be used to determine the value of a company (enterprise value), but the two most usual are those of intrinsic value (relative valuation) and relative value (relative valuation).
Intrinsic value
In this approach, the company will be valued for its future cash generation capacity and not for its book value. This method is based on the present value of future cash flows that are discounted at a business risk-adjusted rate (DCF in English). This approach makes it possible to calculate the value of any company, however unique it may be, but it requires in-depth knowledge of the business and a subjective evaluation of the drivers that generate value, in order to estimate future cash flows, growth rate and the risk-adjusted discount rate that will be used to calculate the present value.
Relative value
In turn, when calculating valuation using the relative value method, or multiples, the company’s value is determined based on the market price of comparable companies (peer group), using a variable common to both, such as, for example , EBITDA. The great advantage of this method is its simplicity and ease of application, allowing to obtain value estimates quickly. On the other hand, the difficulty of finding companies that are really similar and comparable, is the biggest problem. This would be one of the difficulties to evaluate a startup, where it has a specific technological knowledge and that there are still no direct competitors.
While the two approaches will most likely result in different values for the same company, it is still important to compare the two models and, mainly, to understand the reason for the differences. This understanding will be fundamental in the negotiation and defense of valuation with potential investors.
Starting Valuation calculations
Based on a usual M&A process, where the entrepreneur seeks new partners to sustainably support the growth of his company, practically all the inputs¹ necessary to calculate the valuation at intrinsic value will be described in detail in the info memo that will be presented to the potential investors. In this way, the planning must be consistent and feasible, a plan that the whole company believes in, and keep coherence with the historical performance presented, so that it does not seem just a piece of fiction.
At this stage, the knowledge that the company has to carry out medium and long-term planning becomes important. Prior knowledge of robust budget methodologies will help during this process. We have already commented in previous articles on the importance of the Matrix Budget and on the Beyond Budgeting methodology (methodology recently used by large companies).
Additionally, it is worth noting that there is no point in inflating the projections with totally new projects.
Potential investors may be interested and willing to pay for the operation that is running, but not to take risks for a new project that they themselves could take on themselves. Finally, it is important to remember that, if on the one hand the conclusion of the M&A operation is the end of a relevant stage, it also marks the beginning of a new partnership; now with new partners that will certainly charge the entrepreneur and other executives to achieve the presented business plan.
After determining the company’s value using the intrinsic value method, it is interesting to convert it into terms relative to current EBITDA (multiples), and compare it with the average observed in closed operations with similar companies (peer group). Here, it is essential to understand how similar, in fact, companies are, mainly in terms of growth rate². In addition, it is also important to compare the company’s relative value with the multiple that the investor’s own shares are being traded on the stock exchange.
It is necessary to understand that the potential investor will have to defend the acquisition with the internal board and shareholders. Thus, any differences found between the multiple of the company, the peer group and the investor himself, should be duly supported by clear evidence that supports it, such as: a more profitable product mix and / or a higher and more sustainable growth rate .
Finally, once the company’s valuation is concluded, regardless of the approach used, the shareholder value (equity value), which represents the value of its shareholding in the company, must be calculated. This is the amount that the shareholders will receive for the sale of the company or, proportionally, by the company. To do so, just subtract the net debt from the company’s value, as follows:
equity value = enterprise value – net debt.
Equity value can also be obtained directly using the discounted cash flow method. But in this case, it is important to note the difference between the company’s and the shareholder’s cash flows. While calculating the enterprise value, cash flow is used from operating income before financial expenses and after income tax (NOPAT in English) and the weighted average cost of capital (WACC in English) as a discount rate ; when calculating equity value, cash flow starts from net income and the discount rate used is the cost of equity.
Valuation: Opportunities and suggestions
In order to maximize shareholder value, some actions can be considered and others should be avoided, for example: i) consider monetizing assets that are not operational and do not generate cash; ii) evaluate the trade-off of sales and leaseback operations, analyzing the impact on cash flow versus the reduction in net debt. Remember, potential investors are interested in the assets’ cash-generating capacity and not in their possession; and iii) avoid drastic changes in working capital management. This will only generate discomfort and questioning on the part of the potential investor’s team. It will certainly require the maintenance of working capital at levels similar to the company’s historical average.
Finally, it is worth remembering that the information provided in this stage will, most likely, be scrutinized in the next stage of Due Diligence. And, certainly, neither the entrepreneur nor his team of executives will want to appear to be unaware of the business itself or that they are simply “selling illusion”.
To those interested in deepening their knowledge on the subject of Valuation, I recommend that they access the website of prof. Damodaram at NYU:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/home.htm
Author Jorge Zanette: Financial executive with over thirty years of experience that mix knowledge acquired in the strategic and financial management of national companies, with family control, and in the credit management of multinational financial institutions. He led, as CFO, the M&A process of two important companies in Rio Grande do Sul that resulted in the entry of an investment fund and a strategic investor.