Valuation in Acquisitions Is More than Number Crunching

Many factors are involved in valuing a company for purchase, but three complex ideas—the real-world value of the company, the experience and credibility of its partners, and identification of a logical, attainable deal—raise important questions that can "triangulate" the process, said Louis Kenter, '84, founding principal of Prospect Partners.

"Does the company exist for a purpose? Does whatever product or service it provides have value, not just financially?" Kenter said during a presentation, sponsored by the Booth Entrepreneurship Through Acquisition (BETA) group, at Harper Center on February 9. "Is there a group of partners that knows the space well and that we can work with? Finally, is there a financial deal that makes sense?"

From a legal standpoint, valuation must carefully consider taxes, each party's desired price and terms, off-balance-sheet liabilities, and covenants not to compete, said S. Michael Peck, AB '69, partner at Sidley Austin, LLP. "The tax code is definitely form over substance very often, and the way you get to the end point of a transaction may have tax and money consequences, in terms of your purchase price," Peck said.

A mixture of stock and cash is often critical in completing a transaction, he said. "Outlying off-balance-sheet liabilities are obviously a sort of hidden price," Peck said. "If there are no surprises, the nominal purchase price may be, in net effect, the purchase price. If there are all kinds of environmental or other off-balance-sheet issues, in net effect that's hidden purchase price."

The top three business and legal issues in a transaction are reaching non-compete agreements, determining indemnification, and properly structuring the deal, he said. "Sellers are very, very focused on caps on their liability," Peck said. "They don't want their whole purchase price to be at risk. Once a deal closes, they want to know for how long and how much of their price could be at risk."

Transaction structures must carefully address the change of control that will occur, he said. "The day before the transaction the seller or selling group owns it all," Peck said. "After the closing, the buying group owns it all. There could be 24 different ways to get from A to B. These are the result primarily of formal differences in our American legal system, yet they have huge money consequences."

The right balance of stocks and assets can be used to both meet a seller's desired purchase price and ensure that he truly believes his own projections for the company, Kenter said. "By doing this we're using a little truth serum," he said. "If the manager would rather have $100,000 in additional consideration today versus $500,000 five years out from now if he hits his projections, he's not my guy. I want him to eat, sleep, breathe, and worry about getting to the $500,000."

The presentation by Peck and Kenter provided several valuable lessons, said second-year student Ryan Varavadekar, co-chair of the BETA Group. "First of all, valuation is much more than just a mechanical cash-flow analysis," Varvadekar said. "Secondly, never underestimate the value of having a good partner, because no contract can protect you from bad partners. Next, don't underestimate the value of working with excellent advisers, specifically on the legal front. And lastly, everything in these deals is negotiable."

—Phil Rockrohr