As you contemplate additional revenue growth through acquisitions, consider these key questions each time you evaluate an acquisition target.
• Why are we buying this company?
• What is the value of this company to our enterprise?
• What is the correct structure for this transaction?
• How will this acquisition be funded?
• How will this acquisition be managed once acquired?
How do a willing buyer and a willing seller arrive at a transaction price?
A voluntarily transaction occurs when both the buyer and seller believe they are receiving a good value in the transaction. It is beyond our scope to fully explain the concepts of reservation price, economic surplus, buyer’s surplus, and seller’s surplus, but references are provided below. In general, you are willing to purchase a business if you believe the cost is below the value of the business to you, and the seller is willing to sell when they believe the proceeds are greater than the business is worth to them.
The underlying value of the business to the buyer and the seller relates to the value of the cash flows received. Simply put, how much cash will this business deliver at what dates in the future? What is the reliability of those cash flows? What cash will I need to contribute to make those cash flows occur? At what rate should I discount cash inputs and receipts that occur at a future date?
The seller should have the ability to project future cash flows as the business is currently configured. The buyer should be able to consider why the company is an acquisition target and project future cash flows that will occur if the business is operated as planned. If the buyer’s calculations of future cash flows exceed the seller’s calculations after adjusting for risk and cost of funds, a transaction should be possible.
These transactions are often communicated as a “multiple”, referring to a multiple of EBITDA. In a given industry, certain multiples become the norm in a period of time. For example, HVAC contractors may change hands for four to five times EBITDA. This compensates the current owner for the cash-flow generating ability of the business, while allowing the new owner an opportunity to increase EBITDA in order to increase the value to the company.
Next: What is the correct structure for this transaction?
Reservation price, economic surplus, buyer’s surplus, and seller’s surplus defined: Ben S. Bernanke and Robert H. Frank (2004). Principles of Microeconomics, Second Edition. New York, NY: McGraw-Hill, p 81. Also, http://bit.ly/EconomicTermsDefined .
EBITDA defined: Robert T. Slee (2004). Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests. Hoboken, NJ: John Wiley & Sons, Inc., p 63. Also, http://bit.ly/EBITDAdefined .