06 Nov 10 M&A Considerations (Part One)
We have posted blogs recently about the importance of seeking expert help when undertaking M&A. It is also important to get a basic understanding of considerations that will be discussed and debated. You don’t want to head into the negotiations blind, this will add time and more importantly cost. This two-part blog covers 10 of the most common considerations that an expert will discuss with you. This post covers off considerations 1-5.
Cash and Non-cash considerations
Cash – the most liquid and least risky payment method (for the target). In cash-only deals, the acquirer needs to have no doubt as to the true market value of the transaction, as there are generally no contingencies. The benefit to the target is just that, it removes contingency payments that are more prevalent in non-cash considerations. For this reason, 100% cash payments are very rare.
Non-cash considerations– Receiving non-cash considerations is not unusual, it’s normal. The most common non-cash considerations include a seller’s note, an earnout, escrow, stock or an equity hold. Seller beware, an acquirer tends to offer equity when they believe their equity is overvalued and cash when the equity is perceived as undervalued. If you are offered cash, ask about non-cash options.
Valuation methods – “What is my company worth?”
Determining what a company is worth is an art, not a science. In the financial services industry, analysts from both buy and sell side firms will come up with drastically different valuations. Generally, this is because analysts are trying to sell a story. You don’t need to become an expert on valuation, in fact, we encourage you to lean on experts for this as it takes years and years of practice. However, you should know the basic methods they use, so you can ask relevant questions about the valuation that is presented to you.
Book Value (BV) – one of the simplest ways to value your business, but also generally the least accurate. BV uses a firm’s balance sheet to determine the valuation with a simple calculation: assets minus intangible assets (patents, goodwill) and liabilities. There are general conditions, with several assets and liabilities being adjusted due to specific considerations (for example internal debt that will get written off after the acquisition).
Publicly-Traded Comparable – companies listed on the stock exchange are required to submit their financial reports semi-annually. The market then values each stock based on this information. The comparable valuation method generally focuses on Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). A multiple is calculated by dividing the stock price by EBITDA. Your company’s EBITDA will then be multiplied by this value to determine a comparable value. The big downside to this is the premium attached to liquidity, which I will cover off in my blog covering off valuation specifics.
Transaction Comparable – Similar to the method described above, but the focus is on actual transactions. Analysts will use the EBITDA multiple of the transaction history. For example, if the average of the last 10 transactions is 10X EBITDA, your firms EBITDA will be multiplied by 10.
Discounted Cash Flow (DCF) – Cash is king. The DCF method is the most common but is also frequently misused (manipulated). In short, the DCF method is driven by the projected performance of your firm in the long run. The analyst will determine your future cash flow into perpetuity, if applicable, and then discount these cash flows back into today’s dollars.
There are three main categories of transactions; a stock purchase, asset sale or a merger. The acquirer and target have to compete for legal interests and considerations within each alternative.
Stock purchase – the acquirer purchases the target company’s stock from its stockholders. The target company remains intact, but with new ownership.
Asset sale/purchase – the acquirer purchases only certain assets and assumes liabilities that are specifically indicated in the purchase agreement. These liabilities are generally related to the assets being acquired. This type of transaction is very common when a company wants to purchase a specific division within another company.
Merger – When two companies combine to form one legal entity. Generally, the target company’s stockholders receive cash, company stock, or a combination of the two. Mergers often require less stockholder approval and are therefore very common for companies trying to grow.
Representations and Warranties
During the M&A process, an acquirer will expect the final agreement to include detailed representations and warranties. Think of these as their protections. These include, but are not limited to, capitalization, intellectual property, tax, financial statements, compliance with the law, employment, ERISA and material contracts.
A warranty – a term of the contract where the seller makes statements about the company, if these statements turn out to be incorrect, the buyer might have a claim for breach of contract. The consequence is generally a payment of the value attached to the untrue statement.
A representation – a statement of fact which is relied upon by the buyer. If it turns out to be false, the buyer may have a claim for misrepresentation and the contract may be voidable. These can be common where a seller paints a picture of the future, which is not the full truth.
It is critical for the target and target’s counsel to review these representations and warranties carefully because breaches can quickly result in indemnification claims from the acquirer. Indemnification claims are discussed in the next blog and can be very costly.
Working capital adjustments
Transactions normally include an adjustment to working capital. The adjustment is generally a part of the final purchase price. The main reason for this adjustment is that the buyer generally wants reassurance that they the target has the satisfactory working capital to achieve the requirements of the business post-deal, including responsibilities to customers and creditors. A typical adjustment includes the difference between the sum of cash, inventory, accounts receivable, and prepaid items minus accounts payable and accrued expenses.