A successful M&A intermediary advisor used to say that valuation is just a tool to open the door to the client. Rumor has it that the valuations he presented to potential clients were of the kind 'outcome first, justification follows' and that the same company could have as many valuations as days of the week.
It is not surprising that many business owners do not think highly of business valuations. Many people do not take health check-ups seriously, either. However, when an M&A intermediary says that valuation is irrelevant, this is a different story.
Yes, a valuation is an imperfect exercise. Yes, many times valuations merely justify a pre-determined number, usually derived under the infallible 'I will tell the client what he wants to hear' valuation method. But when it comes to putting a deal together, surely valuation cannot be irrelevant. Or can it?
When Are Valuations Irrelevant
In the real world, the 'this is how much I need' valuation is indeed irrelevant. On the other hand, a valuation will certainly not determine the outcome of a negotiation. Many times clients on both sides attach an authoritative status to valuation and strongly reject any offer that deviates from the 'fair' valuation number.
The truth is that valuation, even if completely undisputed, can only set the stage for the players. The final outcome will depend on the players themselves.
All you need are willing buyers and willing sellers. Right? Get them on the table and you will have a deal. Don’t worry about the valuation, they will sort it out, somehow.
Well, if you are lucky, this is (almost) true. Even before the dot.com situation, the Athens Stock Exchange Stock witnessed a bubble of colossal proportions. At the time, valuations were irrelevant. It did not matter what the business was producing; it did not matter how good the business was: all that mattered was for the business to have a story, to be contemplating acquisitions and to have at least one ratio — PE, EV, EBITDA ... pick whichever suits you — lower than its peers. And when somebody said that “Company X cannot be worth €1 billion, it is clearly overvalued" the answer invariably was “how can you say it is overvalued since it has a price-to-book value of four when all other companies in the sector have a ratio of five?"
Valuation, at the time, could be summed up with the following joke:
“Hi, nice dog. How much did it cost?”
“Are you crazy, you paid €100 million for a dog?”
“Of course not, I am not stupid! I exchanged the dog for two €50 million cats”
In this environment, where big was beautiful and any acquisition would send the stock price climbing, valuation was indeed irrelevant. Or to be more accurate, the only thing that mattered was that the target company had slightly lower multiples than the acquiring company.
How many times will a business owner find himself in a situation like that? He wants to sell, many corporate buyers want to acquire his business and money is cheap at the same time. Sounds like a seller’s dream, and it is. And, more importantly, it does not happen that often.
Are there any other instances where valuation is irrelevant? Well, you
could argue that when the parts of the business are worth more than the
business itself (i.e., no goodwill) valuation is irrelevant. But even in
this case, a machinery and equipment appraisal is in order. And if you
think you are 'just selling your inventory, so what's the fuss?', think
again. The buyer is thinking how much he can expect to sell, not how
much you are willing to get rid of.
The Purpose of a Valuation
The purpose of a valuation, and its resulting benefit, is not to arrive at a reasonable starting price, per se. Yes, the purpose and testament of the asking price is to bring interested parties to the table. If it does, then it has been correctly determined. But the true value behind a valuation is to get the seller to look at his business through the eyes of the buyer.
If we just wanted a reasonable starting point for negotiations, we would not need to compose lengthy valuation reports. The final number would be sufficient. And if you have been presented with a valuation report where the only takeaway is the final price, you have been sold short.
Let's say you have a pretty nice-looking company, doing €1,200,000 in sales, and your EBITDA is €250,000. Apply a multiple of four, and we arrive at your proverbial million.
How much money do you need to finance the running of your business each year? You give customers 90 days credit, you keep 60 days of inventory and your suppliers give you 30 days' credit. So you have to finance accounts receivable of €300,000 (1,200,000 X 90/360), inventory of €200,000 (1,200.000 X 60/360) and your suppliers are financing €100,000 (1,200,000 X 0.5 X 30/360, assuming 50% gross margin). Thus you need €400,000, every year, in working capital.
Now let's assume that since you have been in business for quite a while and you are approaching retirement you are not running a very tight ship. Many customers are your friends, and you do not like pushing them too much. The industry norm is 60 days' collection. And two months' worth of inventory is not really necessary. Everyone else in the industry keeps it down to one month, but you like to play it safe. And since you are selling the business anyway, who cares?
Well, the buyer does. And these two little luxuries you enjoy from not running a tight ship cost the buyer money. €150,000 to be exact!
Change your receivable days to 60 and your inventory days to 30. Your accounts receivable are now only €200,000, your inventory is only €150,000 and your accounts payable are the same at €100,000. Your working capital requirement has now been reduced to €250,000. Same company, same profits, but less money needed to finance its operations. The buyer’s return on investment has just improved, dramatically. Don't you think that should have been in your valuation report?
Thus, if you are lucky, under very rare circumstances, valuations may be (almost) irrelevant. In all but those cases, valuation will help you sell your business faster and at a better price, since you will have a thorough understanding of the buyers’ thinking.
But there is more to it than that. Calculating the value of a business should not be a one-off exercise. Calculating and maximizing the value of a business should be an ever-lasting pursuit.