M&A transactions are a way for shareholders selling shares to create and leverage value. Value is created not only when fresh funds are injected into the company in the course of a capital increase, thereby supporting future growth, but also, for example, when a minority stake is sold to a strategic investor, whose resources can then in turn be used at various levels.
It can be said that values are leveraged if one or more shareholders sell their shares in full. Everything you wanted to achieve with the company is then achieved. One could say that, if many entrepreneurs were not completely uninterested in the future of the company, regardless of their shareholder position and monetary incentives. Also, there are of course equally opportunities in a 100% company sale to let entrepreneurs benefit from the future development of the company.
For most readers, it is obvious that whether it is to facilitate the creation of future value or to leverage it, the valuation of the business is central to the transaction.
Accordingly, the various methods for determining enterprise value occupy some space in corporate finance articles. And I too, at an earlier stage of my consulting career, was able to get excited about what income-value-based, market-value-based, and multiple-based methods look like and how to reconcile what are usually divergent results.
But does this help in the transaction, or is this just one of the many loops the consultant pulls to illustrate his savvy, his competence. The answer also depends on which case you are dealing with.
In fact, all three methods mentioned en passant are dependent on parameters such as – by way of example only – sales or the various definitions of earnings by cost. These are present to a lesser extent in an early stage company, if one illustrates, for example, a startup that is investing heavily and perhaps also still before the revenue generation phase, i.e. “pre-revenue”. Which is not an absolute obstacle, a credible forecast can be worked on.
At a later stage, one usually has a plethora of parameters that can be brought into a business valuation to finally celebrate all of the above procedures and more. Much of the data needed for this is gathered anyway in the course of financial analysis and planning.
This means that there is nothing to prevent a company valuation either in the early or in the later company phase, and yes, one should have dealt with the subject, although valuations do not make sense in the form that one could present them to an investor and point out that one had already anticipated the negotiations on this.
And yet, the fixation on business valuations in transactions is more wrong than right. Successful transactions are always the result of a certain prudence (and of circumstances that one cannot influence alone, as one must always add in fairness). And prudence involves paying attention to a whole range of factors that have little to do with “agreeing” on a company’s valuation.
In a broader sense, these factors include issues such as the potential buyer/investor, its shareholder structure, agreement on the parameters of the transaction among the shareholders, reliability, which is evident even long before a signed LOI, long-term strategic vision, and possible short-term tactical motives for engaging with the market segment to which the target company belongs. Some of these issues are trivial, others not so much, but all are critical to the likelihood that commitments made, whether signed or not, will be honored.
Closer to the subject of business valuation but still not covered by it, is the structure of the transaction. When exactly – in the case of financing – should which sums be invested under which conditions? The question of structuring any earn out (i.e., the portion of a purchase price that is still “to be earned”) in a company sale is similarly exciting. In both cases, one could state that the supposed negotiation success of a company valuation is completely relativized by these framework conditions.
Then, and here we come to the core issue, enterprise valuation in the corporate transaction market is synonymous with gross enterprise valuation (“enterprise value”). A distinction must be made between the purchase price paid to the shareholders (“equity value”). To get an idea of the derivation, liquid funds are added, any liabilities are deducted and net working capital is taken into account. But how do you deal with this if the company has built up an above-average inventory or accounts receivable balance?
Ultimately, and in the context of this short article, this can also only be hinted at, in the context of the negotiation of the financing agreement or the purchase agreement, i.e. in a phase where most entrepreneurs would believe to have survived the “worst” (including any due diligence), central issues such as the formulation of seller guarantees or “leaver” guarantees are still often discussed, even in the final stages. regulations literally on the brink. And this sub-process, too, can give one such pause for thought that what one thought was a successfully negotiated company valuation seems almost beside the point.
This may help to understand why “transactions” and “valuation” are often mentioned in the same breath, but there are a whole range of factors to consider.
And ideally, you think of all these constraints before you even name the first number.