Outline for a New M&A Valuation

Practice Area for a Law Firm

Michael A. S. Guth, Ph.D., J.D., Practice Leader

This outline describes the M&A package that our law firm would normally prepare when retained to find targeted acquisitions for a client. If we are retained by a seller, then this outline describes the information on our client that we would present to potential buyers. Any potential buyer will have the standard set of key questions that must be satisfactorily answered before the buyer will agree to the acquisition.

1. Is the target company gaining, holding, or losing financial ground?

2. What is the market value of the target?

3. How much should the buyer pay?

4. What will the purchase ultimately cost?

5. What is the best way to structure payment?

6. What is the most appropriate amount and form of financing?

7. How will the company perform in the future?

8. What is the projected ROI (return on investment) for the buyer?

To assist the buyer, we will develop a sequential, task-specific presentation that answers these questions. The outline for our presentation should follow the six main stages of an acquisition: financial analysis, valuation, purchase price negotiation, deal structuring, financing, and closing.

First, we must construct, with the clients assistance, a database of financial information about the target company. With this database, we can guide the prospective buyer through analyzing the company's financial position, projecting its future earnings, and estimating its market value. The estimated market value provides a benchmark for determining an appropriate purchase price and other key terms of the deal. We then present alternative financing strategies using a variety of common acquisition methods.

Once we have some initial assumptions and specific terms from the prospective buyer, we should prepare a second-round presentation tailored to that buyer. This second presentation would include the buyers proposed purchase price, structure, and funding terms. The buyer will also specify assumptions about the target's future earnings using the projected income statements, balance sheets, statements of cash flows we provide him. The buyer will be interested in whether his acquisition of the target meets its internal threshold ROI for new investments. Graphic illustrations should be utilized throughout the presentation to display the financial information.

The research required to prepare this initial and follow-up presentation would give us the necessary background to negotiate the acquisition from a position of strength. As the negotiations unfold, we should be prepared to show the impact of changes in terms of the purchase contract to the buyer.

Section 1: Historical Performance

Ideally, we would track 1 - 10 years of the targets financial performance. This track record gives potential buyers a realistic look at the trends and underlying financials of the target. This section will answer such questions as

$ Is the target gaining, holding or losing financial ground?

$ Is working capital increasing or decreasing?

$ Is the target sustaining itself on operating cash flow or relying on outside financing?

$ What are the trends for return on investment, assets, and equity?

$ How is the target performing compared to other companies in the industry?

We will need to generate Statements of Cash Flows, Sources and Uses of Funds Statements, and Statements of Retained Earnings. Business ratios and common size financial statements must also be calculated.

Section 2: Forecasted Performance

This section presents the buyer with a step-by-step guide through the targets projected financial statement, which is supported by our financial database. This section must provide realistic insight into the targets growth potential and answer such questions as

$ What is the future earnings capacity of the company?

$ Does the target have sufficient working capital to sustain growth?

$ Are asset levels adequate to support future growth?

$ If not, what is a reasonable estimate of the amount of assets to be purchased?

$ Is there enough cash to purchase or put a down payment on needed assets?

The buyer will want to see how each line item in the Income Statement and Balance Sheet has fed into our (accurate) forecast of future performance. The result is a set of fully linked projected financial statements, including Income Statements, Balance Sheets, Statement of Retained Earnings, Statement of Cash Flows and Sources and Uses of Funds. This detailed projection serves as the foundation for establishing market value and the amount that the buyer is willing to offer for the target.

Section 3: Market Valuation

This section will present an industry-accepted valuation model using several financial approaches, e.g., market value, accounting value of assets and liabilities, and earnings growth and income. After viewing this section, the buyer should have a realistic value for the target and price range to offer us. This section will address question like,

$ What might a ready, willing and able buyer pay?

$ How does the elimination of discretionary and non-operating expenses affect overall value? Does the value of the target reside in its earnings, asset base or the market for similar companies?

$ How does historic performance affect future earnings expectations?

The buyer may derive a valuation based on different measures of earnings including net cash flow, net income, EBT, EBIT and EBIDTA. We should be able to demonstrate the value of the target using any of these measures. After viewing the individual valuation methods, the buyer can select the most appropriate single approach or weight the approaches to arrive at an average. Estimated market value gives the buyer a reference point for determining how much to offer.

Section 4: Deal Pricing & Structuring

The buyer will no doubt want to determine the price to offer and how to structure its offer outside our presence. Nevertheless, we should provide the buyer with a sample step-by-step procedure to determine its offer price, so that we will be hinting to the buyer what price we expect to hear back from it. Any departure from that price would give us a psychological advantage: the buyer would feel it had to justify any lower offer. To structure the deal, this section should estimate the transaction costs and determining the necessary cash to close the deal.

$ What is the most the buyer can pay and still achieve its required ROI?

$ How much of the purchase price will be allocated to tangible assets, covenant-not-to-compete, or stock?

$ How much of the purchase price will be allocated toward management or employment agreements?

$ How much cash will the sellers receive at closing and what portion will be deferred?

$ What is the anticipated value of any contingency payments?

To determine the optimal way of structuring and financing the transaction, the buyer will need to be able to "lay in" deal terms and financing options and analyze the bottom line effects of the terms.

Section 5: Funding

Although obtaining funding for the acquisition is technically the buyers responsibility, we can increase our chances of completing the sale if we eliminate the guess work from financing the acquisition. Essentially, we need to show the buyer a best funding plan that creatively utilizes all funding sources and financial instruments available to the buyer.

$ How much secured debt can the target borrow against assets?

$ Does the cash flow support the acquisition financing?

$ Is acquisition financing placing too great a burden on working capital?

$ Will the target be solvent after acquisition financing?

Whether this deal requires a simple bank loan or multiple levels of complex funding, we can tailor a sophisticated financing plan that fits the target's asset base and cash flow. Financing vehicles include: short-term notes; inventory and receivable revolvers; term debt with extended payments options such as interest and principal deferrals, amortized or level principal repayments, equity-kickers (warrants and options) and convertible debt; and common, preferred, and convertible-preferred equity.

Section 6: Forecast Financial Performance After the Transaction Is Complete

Our work is not complete until we present the buyer with projections of company performance - both pre- and post-sale. This section will reassure the prospective buyer of the bottom line impact of its deal structure and financing scenario.

$ If labor and/or materials increase by a given percentage, how will it impact gross margin and operating profit?

$ How will fixed asset purchases and disposals affect the target's balance sheet?

$ Do opportunities exist to maximize working capital by changing credit and collection policies or inventory management?

$ Are there cash reserves and additional credit capacity to handle unforeseen changes in the business cycle and climate?

$ What is the target's dividend generating capacity?

To forecast the target's performance after the sale, the purchase price and structure, funding assumptions, and planned policy and operational changes must be pulled together in detailed, cross-referenced Income Statements, Balance Sheets, Statements of Retained Earnings, and Statements of Cash Flows and Sources and Uses of Funds. A sophisticated buyer offering as much as $25 million for the target will want to see the bottom-line impact of its operating assumptions and fiscal policy on a line-by-line basis. The result should be a very clear, well-documented picture of the anticipated performance and cash flows resulting from the target acquisition.

Section 7: Return On Investment

This section will answer such questions as

$ Are critical ratios within acceptable levels?

$ Are there income statement or balance sheet line-items that require increasing levels of financial resources?

$ Can the target satisfy the financial covenants imposed by a lender?

$ What might the target be worth in future years?

$ If investors exit in a given year, what is their anticipated ROI on a fully diluted basis?

A thorough internal rate of return analysis will let the buyer structure equity financing for different investment partners based on the initial investment, exit period, projected value, and percentage ownership interest. In each scenario, the buyer will be able to calculate its anticipated ROI on a fully diluted basis.

Having completed the background research and financial analysis to prepare these presentations, we will be able to show strength during pressure-filled negotiations. We will also be able to handle any surprises that arise during the due diligence phase of the acquisition, or unexpected changes in the financing terms.

ADVANCED PRESENTATION

On larger deals, we might anticipate that the buyer would retain a Wall Street investment bank as its advisor. In more sophisticated transactions, we might be requested to present our analysis using

$ a Z-score model to measure the probability of the target becoming insolvent within the next 12 months. This popular model helps assess viability, both before and after the acquisition.

$ a sustainable growth model measuring the maximum growth rate of sales that is sustainable without depleting financial resources. This analysis helps determine whether revenue growth assumptions are in-line with profit margins, dividend payout, asset turnover, and financial leverage assumptions - both before and after the transaction.

$ an enhanced build-up method of developing discount rates in business valuations, particularly for small valuations or when no comparable companies can be identified.

$ a Capital Asset Pricing Model (CAPM) method of determining discount rates. The CAPM is generally preferred over the build-up method because it utilizes beta factors from comparable companies.

$ a debt-free discount rate, a special calculation that adds the weighted average cost of debt and the weighted average cost of equity, used to discount projected EBIT, EBITDA, or Free Cash Flow in the discounted future earnings valuation method.

$ additional valuation methods including Price to Gross Cash Flow, Price to Operating Cash Flow, Price to Dividends, Price to Net Asset Value, Price to Total Assets and Price to Stockholders' Equity.

$ a cash maintenance revolver routine that maintains a target cash level in the projected balance sheets, thus eliminating wildly fluctuating projected cash balances by borrowing from short-term financing instruments when required, paying them down with excess cash, and placing further cash reserves into interest-bearing cash equivalents.

$ preferred stock valuation, if any, based on the market yield of the preferred stock of comparable companies.

$ minority interest valuation, to determine the value and structure the acquisition of a minority ownership interest in a company. This feature will only occur if one of the current shareholders of the target chooses not to sell its shares to the buyer.