» How Much Will a Strategic Buyer Pay?

When selling your company to a strategic buyer, understanding how strategic buyers will view and value your business can help you level the playing field and maximize your transaction.

Strategic buyers purchase and then integrate businesses, so they leverage synergies to generate gains in the near term as the result of careful integration planning and execution.This is in sharp contrast to private equity firms that purchase businesses with the intent and need for a second sale transaction in order to realize gains.

Synergies Overview

Strategic combinations or acquisitions usually present significant near term opportunities for value creation from synergies within 3 to 18 months.
Synergies create value when opportunities to increase sales, eliminate redundancies, and streamline operations are realized by the buyer after closing.
To fully realize synergies, the buyer must have a thorough integration plan and the partner or buyer must execute its plan to carefully integrate, or combine, the operations of the acquired business with buyer’s operations.
Synergies lead to improved financial performance and therefore a higher worth for the acquired company when owned by the strategic buyer. Synergies may be categorized as shown in Figure 1.

Types of Synergies

Sales synergies reflect incremental sales that may accrue to a strategic buyer such as expanding the geographic distribution of acquired products through the buyer’s distribution channels, lowering distribution costs for the acquired products, cross- selling the acquired products to the buyer’s customers, and similar revenue opportunities.
Manufacturing synergies include supply chain and production related savings. Strategic buyers usually bring economies of scale to material purchases, a diverse and compliant supply chain, and an efficient procurement function. Significant production savings may result from combining production facilities to increase scale, leverage global manufacturing sites, and reduce facility related overhead costs.
SG&A synergies reflect savings from leveraging the buyer’s staff functions and eliminating redundant personnel in such areas as finance, administration, outside services (e.g. legal, payroll processing), and eliminating duplicate or unneeded R&D programs.
Capital expenditure synergies often occur when capital expenditures may be reduced or eliminated e.g. if the strategic buyer already has excess capacity in an area planned for expansion by the acquired business.
Working capital synergies result when the buyer is faster collecting on accounts receivable and/or slower paying suppliers than the acquired business. (For example, if the buyer turns working capital 6 times per year and the acquired company turns working capital only 3 times per year, then there is some cash that may be made available by migrating working capital turns for the acquired business from 3 to 6.)

Synergies can be a substantial source of near term value creation, typically ranging from 10% to 100% of the base economic stand-alone value. Of course, there are costs involved to realize synergies and these costs offset the financial benefits of synergies to some extent.

Costs

The costs of synergies include such items as retention bonuses for employees during a transition period, severance, production process documentation, asset moves, information system upgrades, facility clean-up, environmental cleanup, and the like.

Total synergies, net of costs, can often add perhaps 50% to the base stand-alone value of the business to be acquired.

Financial Engineering

Financial engineering can be the source of significant and immediate value creation. Sometimes, the value creation from financial engineering can be so great as to almost pay for the entire acquisition.

Financial engineering creates shareholder value upon closing as a result of one or both of these factors:

valuation multiple expansion
margin arbitrage

Typically, a highly valued and well performing strategic buyer, often a public company, will acquire a smaller privately held or lower performing public company. In such cases, the strategic buyer will likely have valuation multiples, such as P/E and Price/Sales ratios that are greater than the company being acquired.

When the strategic buyer has higher valuation multiples than the target company, then the market will likely apply the buyer’s valuation multiples to the target company’s sales and earnings when the transaction closes, as illustrated in Figure 2.

This upgrade in the valuation multiples is especially likely when the buyer is much larger than the acquired company, the buyer is perceived to be better managed than the target, the transaction is perceived to provide many opportunities for synergies, or the target is privately held so that it incurs an illiquidity discount and/or its valuation multiples are not publicly known.

Suppose a publicly held strategic buyer with a P/E multiple of 20 acquires a smaller, privately held target company having a P/E multiple of 10. Upon closing such an acquisition, the public market will apply the higher P/E multiple of 20 to the earnings of the acquired company. Accordingly, the shareholders of the strategic buyer will immediately achieve an increase in market value for the combined business equal to twice the actual price paid for the acquired company.

Margin Arbitrage

Strategic buyers usually finance an acquisition with cash on hand or available debt. Typically, the rate of return for cash on the balance sheet and the interest rate for debt financing are both significantly below the rate of return for the business being acquired.

When the acquired business produces a rate of return (after tax cash flow divided by the price paid for the company) greater than the rate of return for cash on hand or the interest rate cost for debt financing, then the buyer will realize a net benefit from asset margin arbitrage.

Managing Risk – Why Deals Fail

Strategic acquisitions can, and often do, fail to produce the desired results for many reasons.

One of the most common issues is the failure to integrate the acquired business and to realize synergies. Failure to integrate may result from insufficient integration planning, a lack of management accountability, or inadequate focus on the integration.
Sometimes, due diligence may be poorly planned or executed resulting in inappropriate business assumptions or understated business risks.
Poor financial modeling and improper financial engineering can lead to an excessive valuation, missed opportunities, or unrealistic financial goals for a transaction.

Of course, all of the gains achieved by excellent integration planning, due diligence, financial modeling and execution can be lost due to poor terms and conditions if the negotiation is not handled carefully.

Conclusions

Strategic acquisitions are the fastest way to create shareholder value. Financial engineering may be employed to create shareholder value immediately.
Synergies may create significant short term value based on thorough integration planning and execution.
Management focus and a robust internal M&A process are required to ensure that all available opportunities for value creation are achieved and risks are mitigated.
Strategic acquisitions properly planned and executed can and will create significant value for your shareholders very quickly.

For more information, contact our team of industry experts at Impact Capital Group