1. The types of buyer.
2. Financial parameters.
3. The general attractiveness of the company.
4. The relative negotiation skill and leverage of the parties.
5. The buyer’s experience with prior acquisitions.
6. The inherent risk factors and the buyer’s tolerance for them.
7. General market and economic conditions and outlook.

I. Type of Buyer:
Not all buyers are created equal. Buyers have different acquisition objectives, growth and competitive pressures, availability of capital and the attendant costs, risk tolerance and adeptness at negotiating deals that impact the amount they might pay for a given company at a given time. The type of buyer you are will impact the price you are willing to pay:

• Bargain hunters are looking to acquire at the lowest possible price; below market rates.
• Financial buyers seek a return on their capital and that return more or less puts a cap on what they can afford.
• Corporate and industry buyers are buying for strategic objectives such as obtaining additional capacity, products, expand sales or diversification. Such buyers are generally willing to consider a premium over market value.
• Strategic or synergistic buyers believe that the “synergies” inherent in the deal will allow it to pay an even higher premium that will be justified on the basis of the benefit of the synergies. If reason is at the helm, synergies will pay for themselves and come from things like revenue enhancement, cost savings, process improvements, and balance sheet composition. However, paying a significant premium based upon anticipated synergies is a risky proposition. Higher prices mean lower margins for error and in many cases synergies fail to be realized.

Bargain hunters are likely to favor valuation approaches that look at tangible asset values or historic earnings using a high capitalization rate. Financial buyers may favor valuation approaches that utilize historic and future earnings. If the financial buyer is entertaining an LBO, the underlying asset values and debt capacity are also a consideration. Corporate and industry buyers tend to consider valuation approaches based upon future earnings and market comparables. Finally, the strategic/synergistic buyer may favor the same valuation methods as the corporate/industry buyer but will factor in a premium for the value of the synergies.

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II. General Attractiveness of the Company:
Naturally, an asking price that is below market valuations is going to make a company more attractive. For that matter, an asking price that is in close proximity to the company’s fair market valuation is also attractive. Factors that make a company attractive include:

• Quality of earnings.
• Growth rate higher than industry norms.
• A strong balance sheet.
• Capacity to support additional debt.
• Leadership or dominance in the market.
• Strong management.

An attractive acquisition candidate encourages a higher premium for two reasons. First, if the overall economics of the business make it attractive, it’s future earnings can support a higher premium. Secondly, as a general rule, an attractive acquisition target is going to attract a larger universe of interested buyers. Given the law of supply and demand, as the universe of interested buyers expands, the pressure increases for a higher premium.

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III. Financial Parameters:
The seller’s financial parameters are pretty straightforward: to walk away with the most after-tax dollars. The seller may have set the negotiation stage with an asking price and may have formed a floor or walk-away price as well. From the buyer’s side, the financial parameters that determine what can be paid for the company include the following:

• Internal cash available for investment in acquisitions.
• The amount they are willing to invest in a single deal.
• The cost of capital (actual and calculated).
• The buyer’s hurdle rate: the percentage required over and above the cost of capital.
• The availability of capital and the terms under which it is available.
• The reaction of the capital markets to the proposed acquisition.

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IV. Relative negotiation skill and bargaining leverage of the parties:
As a buyer, the premium you will need to pay will be influenced by your negotiating skills, bargaining leverage and time constraints. In negotiation, power is derived from your perceived ability to fulfill needs. The buyer offers the seller liquidity, personal freedom or the opportunity to further develop the company. The seller offers the perceived economic advantages of owning the company. The greatest power possessed by both seller and buyer is to walk away, to end the negotiation process—the power of ”NO!”

Both buyer and seller will enter the negotiation with a set of expectations and assumptions. The seller’s expectations will be influenced by the size and attractiveness of the company along with the advice received by I-Bankers and other advisors. If there are a number of potential suitors for the company, the seller’s will tend to drive a harder bargain. A good I-Banker working for the seller is going to create a process and negotiating environment that is going to encourage the highest and best offer. The pressure to “pay top dollar” may be subtle, but it is there.

As a buyer, you want to manage the seller’s expectations. On one hand, you want to project yourself as a capable buyer. On the other hand, you want to make it clear that you are looking for a reasonable and fair purchase price package.

While “cash is king,” the human touch can and does play a vital role. A promising acquisition can be derailed by a faux pas or an overly aggressive approach. You want to sell yourself, your company and your vision of the future. If you ask questions and listen, the seller may reveal their needs. With some creative problem solving and salesmanship, you might be able to craft a purchase price package that is acceptable without paying a needlessly high premium.

Time plays a vital role in acquisition negotiations. Time can be an ally for one party, an adversary for the other. If the buyer is under pressure to complete the deal by a given date, there may be a tendency to relax resistance to pricing issues. On the other hand, if the seller is under a deadline (self-imposed or otherwise), then that creates a willingness to be flexible on price and terms. In most cases, the buyer and seller will attempt to keep their time constraints confidential as knowledge of them gives a definitive edge to the other side.

• A high premium compresses time. The seller can easily agree and will usually be motivated to get the contracts drawn and transaction closed quickly.
• If the business is burning cash, is under increasing competitive or regulatory pressures or if the seller is facing a deadline, the passage of time puts downward pressure on the premium needed to get the deal done.

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V. The buyer’s experience with prior acquisitions:
The premium that a buyer is willing to pay is influenced by prior experience. If the buyer paid a high premium in the past and the acquisition failed to deliver expected benefits, they are going think long and hard before offering an overly generous premium. The reverse may be just as true. If the seller has experience in the industry, they may be apt to pay a higher premium because they have a greater degree of comfort with their ability to make the deal pay off.

Experience within the industry reduces the downward pressure on the premium. The buyer’s prior experience provide him with:

• An understanding of the relative value of companies in the industry and the drivers that influence value.
• A deeper understanding of the strengths and weaknesses of the company and how it compares to others in the industry.
• The existence of procedures and systems to insure a smoother transition and the exploitation of existing opportunities.
• Knowledge of the industry makes it easier to identify financial shenanigans and separate substance over form.
• A better understanding of the risks facing similar companies and the industry.

On the flip side, a lack of positive experience in the disciplines of corporate acquisition and post-acquisition integration encourages a lower premium, not because of the company, but because of the buyer’s recognition of a higher probability for a bad outcome.

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VI. The inherent risk factors and the buyer’s tolerance for them:
Risk can be defined as the possibility of a bad outcome or, stated another way, the uncertainty of a desired outcome. Tolerance of risk is your willingness to accept and manage the risks. Risk management is the action that you take to reduce the possibilities of a bad outcome and increase the odds of a desired outcome. When it comes to negotiating the purchase price package, the biggest risk is that you will agree to a purchase price package that does not make economic sense—overpaying!

When it comes to the risk of acquisition pricing, there are two key principles:

• The lower the inherent risks of owning the company, the higher the premium a buyer might pay.
• The higher the premium paid, the greater the risk.

The evaluation and due-diligence process should address these and all other inherent risks:

• Key customer dependency.
• Key employee dependency.
• Market uncertainty or growing competition.
• Weakness in the supply chain.
• Existing or pending litigation.
• Existing or pending governmental regulation.

If a buyer wants to acquire a company, there are two avenues to a higher return:

• Pay less for the company.
• Implement a plan to increase the company’s earnings once the transaction is closed.

When banking on increased earnings to justify a higher premium, keep in mind that the greater the number of positive outcomes assumed, the greater the odds of an undesirable outcome.

Once you identify the risks, the next step is to determine if can you tolerate them. If the rewards are sufficient and confidence (not overconfidence) in a positive outcome is high, it may all be worth the risk. Ideally, the risk should be quantified. In a potential worst-case scenario, a buyer might pay an exceedingly generous premium and find that anticipated synergies are just not there. In that case, they may find themselves divesting the company for a price closer to the fair market value. In such a case, the risk is the spread between the offered price and fair market value.

Obviously, if you are betting the farm on an acquisition and paying top dollar, you are placing the parent in a very risky position. A failure can have a potentially crushing impact on the parent and its shareholders. Conversely, the larger the buyer’s overall capitalization and liquidity in proportion to the transaction, the more tolerable the risk. In this case, the cost of failure, while distasteful, can be tolerated with little impact on the parent and shareholders.

Finally, the purchase price package and the manner in which the transaction is funded are going to place additional demands upon the company’s cash flow. Such additional demands on cash flow impact the company’s liquidity, working capital and ability to obtain future financing, result in an additional risk.

The seller’s tolerance for risk could be reflected in a willingness to accept stock, un-rated paper or earn-out and contingency agreements.

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VII. General market and economic conditions and outlook:
Economic and market conditions strongly influence the buying decisions of both corporate decision makers and consumers. The impact on the bottom line can be profound.

In boom times, making money can be like shooting fish in a barrel. Expansion capital is available, lenders are willing to say yes, consumers are feeling confident and have money to spend on your products or services, CEO’s and CFO’s are approving all kinds of spending requests. Some things to keep in mind include:

• Favorable economic conditions and a growing market can disguise problems with the company that will not surface until such conditions contract.
• The favorable economic conditions will likely lead to higher earnings, a higher fair market valuation, and higher seller expectations.
• Your view of the future determines how much of a premium you might offer.
• Your view of the future is probably wrong.

While favorable economic condition encourage higher premiums, it’s important to recognize that such conditions are usually temporary. The more dependent you are upon such favorable externals, the greater your risk of reaching the point where you feel squeezed by lower margins and the premium you paid (and wished you hadn’t) when times were good. Remember, almost every I-Banker in the country is telling their clients that the best time to sell is when the company has reached its peak!

Collateral Value is the amount of available secured credit based on the percentage that can be advanced against the estimated, appraised value of individual assets.

Insurable Value is the value used to determine the amount of insurance coverage that should be carried to fund buy-sell agreements or for liability, property and casualty insurance purposes.

Market Value is the price a business would command in an open market when exposed for sale for a reasonable period of time.

Fair Value for financial reporting is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For state legal matters pertaining to shareholders, Fair Value is generally defined by statute.

Fair Market Value is the price, expressed in terms of cash or equivalents, at which a business would be sold between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both parties have reasonable knowledge of the relevant facts.

Impaired Goodwill Value is a reduction in the value of Goodwill arising from annual valuations necessitated by FASB No. 142.

Fundamental or Intrinsic Value is the value that an investor considers, on the basis of an evaluation of available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion.

Investment Value is the value to a particular investor based on individual investment requirements and expectations.

Break-Up Value is the total value of a company’s separate operations (divisions, subsidiaries or business units) if they were sold separately on the open market.

So, the headline says EBITDA is a measure of earnings—simple enough. But then the confusion about this acronym for Earnings Before Interest, Taxes, Depreciation and Amortization reveals itself in the opening sentence: “Ebitda is used as a measure of a company’s cash flow and is instrumental in designing covenants for debt and profitability.”

In that single simple sentence, the author captures the confusion between earnings and cash flow, and illustrates the desperate need to standardize the definition of terms that are used daily within the M&A and corporate finance universe.

There is no need to define, redefine or modify the definition of EBITDA. The term is not a measure of cash flow. The term is a hybrid, a creation of the leveraged buyout world.

In a prior article entitled Forget About EBITDA, we pointed out that the term “gained prominence within the LBO community during the 1980s because it represented the gross dollars that could be made available to service acquisition debt. At that time, EBITDA was more relevant because the deal criteria of the typical LBO sponsor excluded companies that required significant investment for capital expenditures, research and development, or inventory. Less re-investment in the company meant that a larger portion of the EBITDA was available to service acquisition debt.”

At present, EBITDA is important to the investment banking and M&A communities for several reasons:

1. Purchase prices are often expressed as multiples of EBITDA. At an M&A networking event, it is not uncommon to meet Business Development associates of private equity groups indicating their preference for deals in the range of X or Y times EBITDA.
2. Purchase price comparables used to value or price a business are often made on the basis of EBITDA. The Guideline Company or Comparable Company Sales are valuation methods commonly used in the market valuation approach. In this case, the analyst first obtains transaction data for the subject company’s industry and similar firms. The transaction data is usually expressed as multiples of one or more base numbers including book value, revenues, assets, after-tax earnings, cash flow or EBITDA. The most appropriate base number and multiple are selected. EBITDA is often selected as a base number.
3. EBITDA and its application in estimating value and purchase price in small business transactions is deeply ingrained because of the limited availability and quality of financial statement data. Sometimes the information needed to prepare a reliable cash flow statement is not available.
4. In the process of underwriting M&A financing, lenders will use multiples of EBITDA as a quick way of determining the amount they will loan on a given deal. Multiples of EBITDA are used to evaluate the firm’s ability to cover principle and interest (P/I) payments. A “high” coverage multiple generally implies a higher capacity to repay and less risk. Conversely, lower coverage implies less ability to repay and greater risk of default. The EBITDA-to-loan multiple will change based upon the credit market in general, a particular lender’s credit doctrine at any given time, and the perceived risk of the transaction. Less leverage generally translates to either lower purchase price multiples paid to sellers, larger equity investment by the buyer or a combination of both. The net effect is to increase the cost of capital and lower equity returns to investors, all other things being equal.
5. Lenders can include the EBITDA to P/I coverage ratio in loan covenant agreements. The borrower is required to maintain certain predefined multiples. These types of covenants are known as Affirmative Covenants (requirements the borrower must affirm or satisfy throughout the term of the loan agreement) and failure to meet these requirements will result in a technical default which gives the lender certain remedies as provided for in the agreement.

The article in Merger & Acquisition magazine goes on to explain that lenders are exerting more effort to negotiate a definition of EBITDA that is acceptable given the specifics of the business. It is pointed out that “lenders may seek a stricter definition that requires more capital expenditures be factored in and taken out of the company’s cash flow consideration.”

What we have here is a blurring of the definitions for EBITDA and Cash Flow. The problem that the industry is encountering is not the definition of EBITDA. That term is crystal clear. The only variable in the calculation is the accuracy and timeliness of the recognition of income and booking of expenses.

Simply stated, the deal pros, funding sources and companies are using the wrong metric. Trying to modify or customize a definition to meet the needs of the moment may be expedient, but in the end it only serves to add unnecessary confusion—as captured by the author of the Merger & Acquisition magazine article.

The metric that the industry should be using is the amount of cash flows that are available to pay debt and equity holders. This metric would start with the After Tax Net Operating Income plus Non-Cash Charges such as depreciation and amortization, a number very similar to EBITDA. However, to stop here would be an error. Capital Expenditures and Changes in Working Capital need to be deducted. The net result is Free Cash Flow available to Total Invested Capital (FCF-TIC).

FCF available to Total Invested Capital measures the amount of cash flow available to pay debt and equity holders. See the accompanying table for the formula for calculating FCF-TIC as well as the formula for Free Cash Flow available to Equity.

While the effort that goes into calculating FCF-TIC is greater than the effort that goes into EBITDA, the metric is far more meaningful. FCF-TIC can be calculated based upon historic, normalized and projected financial statement data.

MoneySoft is an advocate of Free Cash Flow and it is used extensively in our deal analysis software. We would like to see this more reliable metric come to replace or supplement the ubiquitous EBITDA. EBITDA may have out lived its usefulness.

In closing, there is a story about a young girl who is watching her mother prepare a roast for Sunday dinner. The girl observes that her mother cuts off both ends of the roast before placing in the pan and oven. “Why do you trim the ends of the roast,” she asks. The mother replies: “I don’t know why…it’s just the way my mother prepared the roast.” Now curious, the mother calls her mother and asks the very same question and gets the same answer: “I don’t know why…that’s just the way I learned to do it watching my mother.” Fortunately, the little girl’s great grandmother is still alive. When asked for the reason why she trimmed the ends of the roast, she replies: “Oh yes, back when you were a little girl, we only had one roasting pan and it was too small, so I would trim the roast to make it fit.”

So, to follow the metaphor, we now have a bigger and better roasting pan known as Free Cash Flow available to Total Invested Capital. It’s time that we stop trying bend the definition of EBITDA to fit our needs and start using Free Cash Flow as the preferred metric for loan advance rates, covenants and pricing multiples. It improves analysis and focuses negotiations on the coin of the deal makers’ realm: available cash flow.