A successful acquisition is where the value of the business purchased at least equals and hopefully exceeds the value of the consideration paid to acquire it. To the buyer, the value of the consideration paid is usually determinable. Accordingly, the bottom line in evaluating a purchase is the determination of the value of the business acquired. Therefore, the buyer must consider what value clearly means to be able to make that decision.
Apart from minor considerations such as self-pride, the value of an investment is simply the ability of the investment to return enough cash to repay the investor their initial investment plus an amount sufficient to reward them for the use of and risk to their investment. In the case of the purchase of a business, this cash can only come from that generated by business operations, proceeds from a sale or liquidation, or a combination of the two.
Practically speaking, the amount of cash that a business can generate is unique to that business, concluding there is a single value appropriate for any business. However, in most purchases, the transaction takes place because the seller perceives the value of business as being less than the money they will receive, while the buyer believes the value of the business as being greater than that amount.
Value differences can arise from at least four sources:
- differences of opinion as to the potential of the business
- factual differences regarding that potential
- application of different criteria
- emotional considerations.
Differences of opinion as to the potential of the business are serious problems. If a buyer believes that the business will grow at 4% and produce 12% EBITDA, one is unlikely to be able to make a deal with a seller who believes that 6% growth and 18% EBITDA are a real possibility. At least, however, this situation presents the possibilities of rational discussion about these differences, during which the buyer should always keep in mind that the seller, however confident they may sound, is more knowledgeable about the weakness of their business as well as its strengths. In negotiations, therefore, the buyer’s effort should be directed toward continuously reminding the seller of such weakness.
Factual differences regarding the potential of the business are most important in accelerating the purchase. Here, we are referring to any circumstances under which the potential of the business under buyer ownership and control will in fact exceed that which the current owners are capable of accomplishing. Such circumstances may be cost reductions through supply chain improvement, better product distribution, provisions of adequate financing and so forth. Of course, any proposed transaction should also be examined for its negative possibilities, such as higher employee benefit costs. If, however, the result is a clear positive, then it is probable that the business does in fact have a higher value to the buyer than to the seller. In this situation, a deal becomes likely. However, it is important to keep in mind that what the seller is selling is what they believe could be accomplished with the business. They are entitled to be compensated for what they are surrendering, not what the buyer’s capabilities will accomplish.
Application of different criteria may produce rational differences in valuation of a business to such a degree as to prevent a transaction occurring. Therefore, a situation may arise where both buyer and seller have agreed upon the cash flow potential of the business and both are using net present value concepts to arrive at their respective values of the business. If the buyer applies a 15% discount rate and the seller a 10% discount rate, the seller will value the business substantially higher than the buyer, with the probable result of no deal. The point here is that both buyer and seller may be acting rationally in the light of the different tax situations and investment alternatives available to each of them. This circumstance creates an almost insurmountable barrier to completing the deal.
Emotional considerations are frequently present and sometimes strong in acquisitions involving entrepreneurs or old family businesses, although they cannot be ignored even in large transactions. Being basically non-rational, they do not respond well to due diligence. There are probably two general ways to handle them, aside from giving in to them. The first is to spend time attempting to woo the seller’s view away from their position. The second is to construct a counterbalancing emotional push.
Buyer’s acumen, analytics, people skills and emotional intelligence are critical for a successful purchase to take place. These skillsets, when employed with deference and diplomacy, significantly increases the opportunity for the transaction to happen.