Acquisition and Valuation of Business Venture

Na, Yong Sik

October 5, 2009 vmaker@empal.com

Issues in Acquisition

Acquisition valuations are complex, because the valuation often involved issues like synergy and control, which go beyond just valuing a target firm. It is important on the right sequence, including When should you consider synergy? Where does the method of payment enter the process. Can synergy be valued, and if so, how? What is the value of control? How can you estimate the value?
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Steps involved in Acquisition Valuation

Step 1: Establish a motive for the acquisition Step 2: Choose a target Step 3: Value the target with the acquisition motive built in. Step 4: Decide on the mode of payment - cash or stock, and if cash, arrange for financing - debt
or equity.

Step 5: Choose the accounting method for the merger/acquisition - purchase or pooling.
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Process Overview

Business Valuation Steps - 1

Define Purpose Understand size & characteristics of Client Assessment of People and Markets Gather Additional Data Recast Financial Statements Ratio Analysis / Industry Comparison
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Business Valuation Steps - 2

Application of Valuation Methods Reconciliation Adjustments Valuation Report

Reasons for giving up the venture

Financial problems (68,6%) Lack of information (48%) Lack of qualification (48%) Deficits in planning (30,1%) Family problems (29,9%)
Overestimation of own resources (20,9%) Influences from outside (15,4%)
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Preparing to sell

Strategic and financial considerations Assembling the transaction team Types of sale processes Pre-marketing Marketing efforts Documents Process
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Strategic/Financial consideration

Strategic

Horizontal vs. Vertical (Distribution) Diversification Eliminate competitor

Growth (organic vs. M&A); relative risk Scale Utilize excess capital (reinvest); returns
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Financial

Auction Process

Deal structuring considerations Due diligence (buy and sell side) Buy side evaluation Bidding process Negotiation The Definitive Agreement Closing the deal
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Components of Value

Statutory Net Worth Embedded Value = SNW+ Value of Inforce Business Actuarial Value = EV + Value of New Business Buyers Value = Actuarial Value + Strategic Value Integration Costs
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Actuarial Appraisal

DCF analysis, where: Distributable Cash flow = After-tax Earnings Increase in Required Capital = Premium + Investment Income Benefits Expenses Commissions Increase in Statutory Reserves Taxes Increase in Required Capital
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Tax Issues

Understanding the impact of federal and state tax issues on M&A transactions

Transaction structuring can be highly tax-sensitive

Post-closing tax opportunities affect the value of the target

Investigating tax issues is an important part of the due diligence process

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Integration

Successful outcome of acquisition hinges on integration! Comparatively little typically spent on integration vs. acquisition Goal is to capture the value drivers used to justify the acquisition to the board

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Making it work

Essentially change management Leadership Speed Communication Planning Project management

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Making it work

Essentially change management Leadership Speed Communication Planning Project management

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Risk and Return

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Valuation Methods Discounted Cash Flow

Machine to produce 100 USD bill in 3 years Risk = 0 Discount rate = 8% (time value of money) No input needed

Value of machine?
(one time in year 3) 100/(1.08)3 = 79.4 (every year) 100/0.08 = 1250
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Discounted Cash Flow

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Discounted Cash Flow

[1/4] Free Cash Flow

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Discounted Cash Flow

[2/4] Calculate Terminal Value

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Discounted Cash Flow

[3/4] Discount Rate

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Discounted Cash Flow

[4/4]

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Liquidation Value

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Relative Value

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Market Comparable

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Exit Value (VC Method)

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Summary Method

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Financial Statement Analysis

Basic ratio analysis DuPont Model (ROE in three parts) Return on assets Asset turnover Leverage Financial Statement Quality Risk of manipulation Risk of bankruptcy
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Preparing Forecasted Financials

1)

Are prior financials reasonable starting point? Prepare forecasted financial statements Utilize excel (including circular arguments) Develop reasoning skills
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2)

3)

4)

Prepare estimates of value

1)

Theory of valuation Numerous techniques but ALL begin with the idea of discounted cash flows

2)

Calculate discount rates Theory and practice very different in this area Finance theory focuses on capital asset pricing model In practice, frequently use build-up method

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PER

Price/earning ratio

Interpretation of the PER Level future equity earnings of the firm. Expected return on the investments made by the firm, ROE.

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Limitations of PER model

Estimates post-acquisition earnings for target for one period, and assumes this level will be maintained. No explicit recognition of the time pattern of earnings growth. Does not explicitly consider the investor-perceived risk of the target firms earnings. Problems in selection of benchmark PER Despite limitations, model provides valuation based on capital market consensus view of value of earnings. Widely used by the investment community.
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EVM / EBITDA

Enterprise value multiple (EVM) Enterprise value /earnings before interest and tax (EV/EBIT) Its cash flow variant Enterprise value/ earnings before interest, tax, depreciation and amortization (EV/EBITDA) EBIT = pre-tax return to both shareholders and debt holders Since most firms funded by equity and debt, sum of equity and debt values = value of the firm or enterprise.

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EVM / Firm value

Adding back non-cash expenses depreciation and amortization, EBITDA = operating cash flow. EVM widely used by investment analysts Asset based valuation Tobins q = Firm value = Replacement cost of assets + Value of growth options
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Fair Market Value

Fair Market Value is defined as the value that a willing seller and a willing buyer, both being informed of the relevant facts about the company, could reasonably conduct a buy-sell transaction, neither party under any compulsion to do so.

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Purposes of valuation

Business Sale Business Purchase Bank Financing Estate Planning Estate Taxes Gifting

Divorce Partner Buy In/Out ESOP(Employee Stock Ownership Plan) Inter-Generation Other

Always dealing with two sides someone wants a higher valuation, someone wants a lower valuation.
One side is frequently the IRS.
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Market Evaluation

Size of Market in area Growth in area Companys Position Top Customers

Concentration Company Growth Desire-ability of product/service Location, Location, Location

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Example - Hightech AG
Valuation of Hightech AG Company founded 2002 Service company Screening for Biotech companies First revenues from screening services Requires investment of: EUR 100000 Financing stage: First Stage Valuation according to DCF method
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Example - Hightech AG
Data of Hightech AG
Good, experienced management Medium market size, little expansion possibilities / ambition Product innovation small, me-too, inexpensive production

Qualitative analyses produces the following data:

Discount rate (d): 35% (medium risk) Growth rate (g): 7%
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Example - Hightech AG

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Example - Hightech AG

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Example - Hightech AG

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Example - Hightech AG

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Example - Hightech AG

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Example - Hightech AG

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