Valuation for M&A

CHRIS M. MELLEN is a managing director with Valuation Research Corporation who leads its Boston office. Previously, he was president of Delphi Valuation Advisors, Inc., which he founded in 2000 and sold to VRC in 2015. Mellen is the author of numerous articles on valuation-related topics and coauthor of the second edition and author of the third edition of Valuation for M&A. FRANK C. EVANS is the founder of Evans and Associates Valuation Advisory Services. A prolific educator and speaker, he is coauthor of the first and second editions of Valuation for M&A.

Preface xi

Dedication and Acknowledgments xv

PART I Introduction 1

Chapter 1 Winning through Mergers and Acquisitions 3

Critical Values Shareholders Overlook 5

Stand-Alone Fair Market Value 6

Investment Value to Strategic Buyers 8

Win–Win Benefits of Merger and Acquisition 10

Computation of Cavendish’s Stand-Alone, Fair Market Value 11

Investment Value to Strategic Buyer 12

PART II Building Value 15

Chapter 2 Building Value and Measuring Return on Investment in a Private Company 17

Public Company Value Creation Model 17

Computing Private Company Value Creation and ROI 19

Analyzing Value Creation Strategies 35

Chapter 3 Market and Competitive Analysis 41

Linking Strategic Planning to Building Value 43

Assessing Specific Company Risk 48

Competitive Factors Frequently Encountered in Nonpublic Entities 53

Financial Analysis 54

Conclusion 59

Chapter 4 Merger and Acquisition Market and Planning Process 61

Common Seller and Buyer Motivations 64

Why Mergers and Acquisitions Fail 65

Sales Strategy and Process 67

Acquisition Strategy and Process 78

Due Diligence Preparation 86

Chapter 5 Measuring Synergies 91

Synergy Measurement Process 92

Key Variables in Assessing Synergies 95

Synergy and Advance Planning 96

PART III Measuring Value 99

Chapter 6 Valuation Approaches and Fundamentals 101

Business Valuation Approaches 101

Using the Invested Capital Model to Define the Investment Being Appraised 103

Why Net Cash Flow Measures Value Most Accurately 104

Frequent Need to Negotiate from Earnings Measures 106

Financial Statement Adjustments 109

Managing Investment Risk in Merger and Acquisition 112

Conclusion 117

Chapter 7 Income Approach: Using Expected Future Returns to Establish Value 119

Why Values for Merger and Acquisition Should Be Driven by the Income Approach 119

Two Methods within the Income Approach 121

Three-Stage DCF Model 128

Establishing Defendable Long-Term Growth Rates and Terminal Values 131

DCF Challenges and Applications 133

Chapter 8 Cost of Capital Essentials 135

Cost of Debt Capital 136

Cost of Preferred Stock 138

Cost of Common Stock 138

Fundamentals and Limitations of the Capital Asset Pricing Model 139

Modified Capital Asset Pricing Model 142

Build-Up Model 143

Summary of Rate of Return Data 151

Private Cost of Capital 153

International Cost of Capital 156

How to Develop an Equity Cost for a Target Company 157

Reconciling Discount Rates and P/E Multiples 159

Conclusion 161

Appendix 8A Using Specific Company Risk Strategically 162

Chapter 9 Weighted Average Cost of Capital 169

Iterative Weighted Average Cost of Capital Process 170

Shortcut Weighted Average Cost of Capital Formula 174

Common Errors in Computing Cost of Capital 176

Chapter 10 Market Approach: Using Guideline Public Companies and M&A Transactions 181

Transaction Multiple Method 182

Guideline Public Company Method 186

Selection of Valuation Multiples 190

Commonly Used Market Multiples 191

Chapter 11 Asset Approach 199

Book Value versus Market Value 200

Premises of Value 201

Use of the Asset Approach to Value Noncontrolling Interests 201

Adjusted Book Value Method 202

Specific Steps in Computing Adjusted Book Value 207

Chapter 12 Adjusting Value through Premiums and Discounts 209

Applicability of Premiums and Discounts 210

Application and Derivation of Premiums and Discounts 211

Apply Discretion in the Size of the Adjustment 213

Control versus Lack of Control in Income-Driven Methods 215

Fair Market Value versus Investment Value 215

Chapter 13 Reconciling Initial Value Estimates and Determining Value Conclusion 217

Essential Need for Broad Perspective 217

Income Approach Review 220

Market Approach Review 225

Asset Approach Review 226

Value Reconciliation and Conclusion 228

Checks to Value 231

Candidly Assess Valuation Capabilities 232

Valuation Scenarios – Platform for M&A 232

Appendix 13A Disciplined and Thorough Valuation Analysis Key to Avoiding Failed M&A Deals 235

Analysis of a Hypothetical Synergistic Deal 235

Establishing the Value of an Acquisition Target 236

Establishing Value for the Acquirer 238

Considerations of Other Impacts on Value 239

PART IV Specialty Issues 241

Chapter 14 Exit Planning 243

Why Is Exit Planning So Difficult? 244

What Makes Planning for Your Private Company Investment Unique? 247

Why Should Exit Planning for Your Private Company Begin Now? 249

Exit Planning Process 250

Step 1: Setting Exit Goals 252

Step 2: Owner Readiness 254

Step 3: Type of Exiting Owner 256

Step 4: Exit Options 258

Step 5: Range of Values 263

Step 6: Execution of Exit Plan 265

Chapter 15 Art of the Deal 269

Unique Negotiation Challenges 269

Deal Structure: Stock versus Assets 271

Asset Transaction 276

Terms of Sale: Cash versus Stock 279

Personal Goodwill 282

Bridging the Gap 283

See the Deal from the Other Side 286

Chapter 16 Fairness Opinions 289

Why Are Fairness Opinions Obtained? 291

The Use of Fairness Opinions by Private Companies 294

Parties Who Prepare Fairness Opinions 295

Components of a Fairness Opinion 297

What Fairness Opinions Are Not 301

Conclusion 302

Appendix 16A Sample Fairness Opinion Letter 303

Chapter 17 M&A and Financial Reporting 309

U.S. GAAP and IFRS 310

Relevant FASB and IFRS Statements 311

Reviews by the Audit Firm 312

ASC 820: Fair Value Measurements 313

ASC 805: Business Combinations 315

ASC 350: Goodwill and Other Intangible Assets 325

Incorporating ASC 805 into the Due Diligence Process 326

References 329

Chapter 18 Intangible Asset Valuation 331

Approaches to Valuing Intangible Assets 332

Key Components to Intangible Asset Valuation 334

Intangible Asset Valuation Methods 343

Conclusion 352

Chapter 19 Measuring and Managing Value in High-Tech Start-Ups 353

Why Appraisals of High-Tech Start-Ups Are Essential 353

Key Differences in High-Tech Start-Ups 355

Value Management Begins with Competitive Analysis 356

Stages of Development 358

Risk and Discount Rates 360

Start-Ups and Traditional Valuation Methods 361

QED Survey of Valuation Methods Used by Venture Capitalists 367

A Probability-Weighted Scenario Method to Value Start-Ups 372

Equity Allocation Methods 377

Conclusion 380

Chapter 20 Cross-Border M&A 381

Strategic Buy-Side Considerations 381

Due Diligence 390

Sell-Side Considerations 395

PART V Case Studies 397

Chapter 21 Merger and Acquisition Valuation Case Study – Distribution Company 399

History and Competitive Conditions 400

Potential Buyers 401

General Economic Conditions 402

Specific Industry Conditions 403

Growth 404

Computation of the Stand-Alone Fair Market Value 404

Risk and Value Drivers 409

Summary and Conclusion of Stand-Alone Fair Market Value 418

Computation of Investment Value 420

Suggested Considerations to Case Conclusion 427

Chapter 22 Merger and Acquisition Valuation Case Study –Professional Services Firm 429

Characteristics 429

Valuation Methods 433

Case Study Introduction 435

Potential Buyer 435

Historic Financial Performance 436

Future Expectations 439

Risk and Value Drivers 443

Discounted Cash Flow Method 445

Other Valuation Methods to Consider 445

Suggested Considerations to Case Conclusion 451

About the Authors 453

Glossary 455

Index 465