The Value-Price Continuum
The price paid for a lawfully acquired business interest is a fait accompli—an accomplished and irreversible fact. The parties have negotiated, had an opportunity to perform their due diligence, reached a meeting of the minds and consideration has changed hands. The transaction is done—the cash register has gone Ka-Ching.
While the price paid is a fact, value is a subjective and relative concept.
At its most formative stage, a notion of value can be pulled out of thin air. The brain has a remarkable ability: Ask it a question—rational or not—and your brain will almost always provide an answer (not necessarily right). Ask what something is worth and your brain will return an answer, although you might not have much confidence in it. Our brains accomplish this through various neuro-associations and by calling upon a number of mental shortcuts (heuristics) such as:
“I know a person who sold a business just like mine for $…”
“A business like this one should sell for 10 times profit.”
“Our firm only looks for acquisition targets in the 6-7 times EBITDA range.”
“Businesses are always priced too high. We only offer half of the seller’s asking price.”
The mental shortcuts at the formative stage of the Value-Price Continuum are quick and easy, but are not usually accurate, reliable or defensible to support intelligent decisions.
Informal valuations provide an estimate of value by applying all or a portion of the calculations that go into a valuation without including all of the procedures a professional would use when preparing a formal valuation.
Informal valuations include DIY (do-it-yourself) valuations and evaluations that might be prepared by a consultant or intermediary. These valuations are typically performed for internal and planning purposes.
Formal valuations are (or should be) prepared by a credentialed business valuation professional. A professional has the intention of providing an independent, objective opinion or conclusion of value using methods and procedures that are accepted within the industry.
The purpose of the valuation determines the definition of value that’s applied by the valuator for a particular assignment (see List of Common Measures of Value for more information).
A business intermediary or broker’s evaluation or market report is a hybrid between a formal and informal valuation. The evaluation or market report can be prepared by or on behalf of an intermediary or business broker in order to help the client understand the market value of the company and establish an asking price.
A business intermediary or broker’s internal valuation is not prepared for outside consumption but rather helps the intermediary determine if a seller’s aspirations are achievable so that a success fee or commission is likely to be earned.
An intermediary can use their internal valuation to prepare a list of talking points to review with the seller to arrive at a mutually agreed upon asking price. An intermediary will also use their internal valuation to better understand their client’s company and to prepare selling materials that are grounded in and square with the numbers.
Once a seller decides to pursue a sale and engages an intermediary to facilitate the sale of their company, a range of values comes into play:
- The market value estimated by formal or informal valuation.
- The seller’s aspirational price — what they hope to get.
- The seller’s bottom-line price — a pact they’ve made with themselves on the least they’ll accept.
- The asking price — the price tag they put on the business when presenting it to buyers.
During buyer-seller negotiations the concept of value continues to go through a refinement process starting with the asking price and moving through the following waypoints:
- The buyer’s analysis and valuation driven by Free Cash Flow Return on Investment or some other earnings metric.
- The initial offer price or bid, which may or may not be accepted by the seller.
- The initial negotiated price subject to due diligence.
- Due diligence may unearth information that results in an adjusted initial negotiated price.
- The final funded transaction price subject to contingencies and earn-outs.
- The final funded transaction price after all future obligations have been fulfilled.
Outside parties that have an interest in the deal may consider the value and price of the transaction from their perspectives:
- Prior to closing, funding sources may evaluate the proposed purchase price package and compare it to their concept of value as part of their evaluation of the risk and funding terms of the financing to be provided.
- In a highly leverage situation, a Solvency Opinion may be required to assure interested parties that the acquisition financing will not subject the company and its creditors to undue financial distress.
- Prior to consummation, a Fairness Opinion may be required when the parties to a deal have a fiduciary relationship with one or more constituencies that will be affected by the deal. As implied in its name, a Fairness Opinion is an opinion from a financial advisor that the deal is fair for a given constituency.
In the final analysis, the negotiations between buyer and seller are — or should be —influenced by three numbers:
- The Net Present Value (NPV) of all consideration to be received by the seller —net of estimated taxes and transaction expenses.
- The NPV of Free Cash Flow that the buyer reasonably expects the business to generate — net of all consideration to be paid to the seller, taxes and related transaction costs and expenses.
- The Discount Rate applied by buyer and seller to arrive at the NPV of their respective metrics.
MoneySoft DealSense® Plus includes the analysis, valuation calculations and financial projection engine necessary to make sound decisions at each waypoint in the Value-Price Continuum. It is used by intermediaries to advise their clients and prepare a company for sale; by valuation analysts to support business planning and prepare valuations for tax and litigation support; and by business buyers to structure price and transaction terms that make economic sense.