Lenders often have a stake in private company mergers and acquisitions, so it’s important that they know whether the target’s price is reasonable. Procuring a professional appraisal upfront can mean the difference between a long-term lending relationship and default. To help make informed lending decisions, lenders should know the standards of value used by appraisers, along with their valuation methodologies. A sidebar to this article points out the dangers of relying on generic valuation formulas.
Value is in the eye of the beholder. As a lender you often have a stake in private company mergers and acquisitions. So it’s important that you know whether the target’s price is reasonable and that the buyer is emotionally detached. After all, a buyer that overpays is more likely to experience financial problems after the deal closes.
Procuring a professional appraisal upfront can mean the difference between a long-term lending relationship and default. Expert opinions also can assuage any concerns you may have, such as whether income projections are reasonable or comparables are truly similar to your borrower. And knowing business valuation terminology, methodology and potential pitfalls will help you make informed lending decisions.
Standard of value
The term “value” can have many different meanings. Strategic (or investment) value refers to the perceived value to a specific investor. A business seeking to increase market share, for example, might pay a premium to acquire a competitor. Strategic value depends on an investor’s individual situation, requirements and expectations.
An important benchmark in negotiating deals is fair market value. Essentially, this is the price the “universe” of potential buyers and sellers would agree on for a business interest. Fair market value assumes no compulsion to buy or sell and reasonable knowledge of all relevant facts. Beware of deals where strategic value is significantly higher than fair market value. Many buyers overestimate the value of synergies.
Another common standard of value is fair value. In an accounting context, it’s similar to fair market value, except that it’s an exit (rather than an entry) price. Moreover, fair value only considers market participants active in the principal (or most advantageous) market.
Accountants use this term when, for financial reporting purposes, they value assets and liabilities such as intangible assets (customer lists, non-competition agreements, etc), goodwill and contingent payment obligations. Some borrowers may have reported goodwill impairment during the recession, for example. This occurs when the fair value of acquired goodwill is lower than the amount shown on the borrower’s balance sheet. These write-offs may foreshadow financial problems.
Methodology
Appraisers apply three approaches to valuing a business:
Cost (or asset-based) approach. The value of a business is the difference between its assets and liabilities. For example, an appraiser might revalue the amounts shown on a company’s balance sheet. This approach is difficult to use on companies with significant intangible value. It’s typically reserved for holding companies and others that rely exclusively on hard assets.
Market approach. This approach generates pricing multiples from sales of comparable (or guideline) companies. Here, value is a function of the ratio of (multiple) selling price and a financial metric, such as annual revenues or last year’s earnings before interest, taxes, depreciation and amortization (EBITDA).
Pricing data can be obtained from daily stock market quotes and, private, proprietary databases.
Selection criteria for comparables might include transaction date, financial performance, industry and size, for example. Finding a meaningful sample of comparables for some companies — especially niche specialists — can be difficult.
Income approach. Appraisers project cash flows and then discount them back to their net present value. Discount (or capitalization) rates are based on the company’s risk profile. High-risk businesses are assigned a higher discount rate, which equates to a lower value (and vice versa).
The income approach may be difficult for laypeople to understand. Sophisticated buyers and sellers are more likely to use this approach. It’s often the preferred method for startups and companies with significant intangible value.
Pitfalls
Methods and definitions explain some of the “science” underlying business valuations. But accurate appraisals also require finesse and qualitative assessment. Experienced appraisers understand subtle valuation nuances and potential pitfalls.
For example, some sellers try to save money by reusing an appraisal prepared for, say, a previous gift tax return or shareholder buyout. Not only can these valuations be out of date, they may include inapplicable valuation discounts or use an inappropriate standard of value.
Valuations are only valid as of a specific date and for a specific purpose. Therefore, borrowers always should check with their appraisers before recycling an old report in a new context. Do-it-yourself valuations present another minefield of potential problems. The IRS and U.S. Small Business Administration recognize the importance of appraisal training and have established “qualified appraiser” criteria.
Before you finance a deal, ask whether the parties have consulted with valuation professionals. Ask for a copy of the written appraisal report, including the financial exhibits and appraiser’s curriculum vitae. Reliable appraisers have years of valuation experience and have credentials from professional appraisal organizations.
Educated decisions
Filtering through the data and arriving at an accurate value requires mastery of both the art and science of business appraisal. Lenders who understand valuation basics and expect borrowers to obtain outside valuation expertise will have a higher likelihood of making wise lending decisions.
Sidebar: Rule out “rules of thumb”
You’ve likely heard at least one valuation formula, such as one times revenues (for professional practices) or five times earnings (for manufacturers). But borrowers and lenders who bank on these “rules of thumb” may be in for a rude awakening after closing.
Oversimplified formulas overlook unique operating characteristics, such as nonoperating assets, exclusivity contracts or in-process research and development, which differentiate the subject company from its competition. Rules of thumb also may be outdated. For example, a valuation formula popularized during industry consolidation in the mid-1990s may not be relevant in today’s turbulent economy.
Another reason to shun rules of thumb is their ambiguity. To illustrate, does “earnings” refer to net income, pretax earnings, earnings before interest and taxes (EBIT), or some other metric?