Strategic Versus Financial Buyers
Standard of Value and Level of Value
As noted earlier, the valuator is charged with estimating the “fair market value” (standard of value) of the subject minority interest (level of value) holdings on a going concern basis (premise of value). Careful consideration of the relevant standard, premise and level of value choices is a necessary component of a credible and accurate business valuation in that these decisions impact the selection of valuation methods, earnings streams and ultimately the determination of value.
The pertinent source of direction for determining the standard of value is found in the LLC’s buy-sell agreement and its amended articles of organization. The buy-sell agreement contains detailed directions as to how members might be subject to “expulsion” and the rights of such members under such conditions. Included in the buy-sell agreement are the directions regarding the hiring of a “disinterested” appraiser to determine the “fair market value of the Interest”.
In addition, the “Amendment to Amended and Restated Articles of Organization of The Company” that was executed on the 4th of April, 2002 states that each partner agrees to abide by a series of conditions which include the following (Section 3a):
“An independent valuator will be hired by The Company to provide an estimate of the fair market value of the violating partner’s shares.”
Although the amendment is silent as to the premise of value and level of value, the “going concern” nature of the subject firm logically precludes the use of an alternative premise of value. By implication, the use of the term “partner’s shares” requires the determination of the relevant percentage ownership for purposes of evaluating the relevant “level of value”.
In the current case, the subject interest is a 23.7% “non-controlling” interest which is “quasi-marketable” (in between “marketable” and “non-marketable”) due to the presence of the buy-sell agreement, i.e. absent the buy-sell agreement, the subject minority interest would be considered “non-marketable” as compared to the “marketable” standard associated with publicly and actively-traded share prices. The presence of the buy-sell agreement may not fully eliminate the challenges associated with selling non-controlling interests in privately-held companies, but it does certainly reduce the level of illiquidity.
When assessing any standard of value including fair market value, it is necessary to understand how the “willing buyer” and “willing seller” would act in assessing business value and in negotiating a final deal price acceptable to both sides. Although there is no planned transaction for ABC, the value of the subject software firm is best estimated through those methods used by intermediaries and entrepreneurs for purposes of establishing asking and offer prices in real world transactions.
The valuator’s experience as a business broker coupled with professional training in business valuation and more than a decade of valuing privately-held firms has led to the opinion that most businesses similar in size and scope to the subject firm are optimally “valued” by way of those methods and perspectives utilized in negotiating actual deal prices.
In addition, the courts are filled with cases that are adjudicated by appraisers and judges seeking to clearly understand the probable interaction of the hypothetical, willing and able buyer and seller that leads to a final “deal price” (fair market value). The following paragraphs and earlier/later sections of the report will address the “standard of value” concept in detail in order to ensure a proper and credible estimate of value for the subject assignment.
The valuator’s experience “in the trenches” is documented in the valuator’s first book called “The Upstart Guide to Buying, Valuing and Selling Your Business” (Dearborn Financial Publishing) and most importantly in his second book titled “The Business Valuation Book” (published by Amacom, the publishing arm of the American Management Association), which presents the proprietary “ARM Approach” to private firm valuation.
This acronym refers to the three “deal-oriented” valuation methods that are commonly used by dealmakers, entrepreneurs and even bankers in deciphering business value, i.e. the ARM Approach incorporates those specific valuation methods used by the “willing buyer and seller” in reaching agreement on price and terms for businesses of a type and size similar to that of ABC.
The subject firm is rapidly approaching “middle market” status based on many years of solid double-digit revenue growth as it has expanded both geographically and in terms of its “target market”. As the company continues its penetration of state after state and as the product offerings are adapted to ever larger school districts, the firm’s revenues, profits and scope of operations will evolve into more of a “middle market” dimension rather than the “business brokerage” segment from which it has sprung. The implications of this evolution are wide-ranging and include the selection and use of pertinent valuation methodologies. Being on the “cusp” of true middle-market status, it behooves the appraiser to rely on a combination of valuation techniques which are suited for both environments.
In order to utilize a valuation method which seeks to value the firm’s equity “directly” and in a manner consistent with middle-market foundations, a fourth method shall be included from the family of discounted cash flow techniques (referred to as “multiple period discounting methods” by professional appraisers) known as “discounted future earnings”. A secondary reason for using this methodology is a desire for consistency visavis the valuator’s original valuation engagement for ABC from fiscal year 2003.
Financial Versus Strategic Buyer
Having determined that “fair market value on a going concern basis” is the relevant standard and premise of value, the next question relates to what the typical buyer will look like for the subject firm if it were to be openly marketed to the highest bidder. It is the valuator’s opinion that the answer boils down to making a distinction between a “financial buyer” and a “strategic buyer”, whereby the latter brings a definitive, buyer-specific set of skills, knowledge and assets to the acquired operations which are likely to produce higher incremental profits and therefore “value”.
As found in the Estate of Mueller v. Commissioner case introduced earlier, the “willing buyer” is:
“A hypothetical amalgam of potential buyers in the marketplace.”
Judge Beghe goes on the record to say that the court has in prior opinions “identified types of hypothetical buyers” in order to determine which valuation approach would result in the highest bid and therefore the one most acceptable to the willing seller.” As such, Judge Beghe believes that the final valuation result (in a court of law seeking to determine probable fair market value) is not the result of an average of “high and low” valuation results but rather the price is determined by an “auction” in the marketplace, not the give and take of one-on-one negotiation. Another interesting quote from this case is that:
“Logically, a willing seller would only sell to the willing buyer making the highest bid.”
In the present case regarding the well-established software company, it is the valuator’s opinion that the probable buyer would be the “strategic buyer”referred to earlier. Although it is possible that a “financial buyer” would be interested in acquiring the subject firm, it is clearly the case that this firm would be relatively more appealing (valuable) to a strategic buyer (another software-related firm) which is capable of leveraging the combined strengths and opportunities of the acquiring and acquired entities. Accordingly, the “willing buyer” is determined to be of the “strategic” variety rather than the “financial” variety.
As discussed in various professional valuation resources that are used by practitioners, “synergism” can arise for a variety of reasons, both financial and nonfinancial. According to the widely-used CCH Business Valuation Guide (Hawkins and Paschall; published by CCH, Inc.), “the issue for the valuator is that financial synergism may have to be incorporated in determining the value a company that might become an acquisition target”. More to the point, the Guide states that under conditions similar to those involving the subject landscape contractor “fair market value can be expected to approach or equal synergistic value.”
Stated simply, the value of the subject firm is greater (all other things equal) to another experienced landscape construction or maintenance firm than to a non-experienced, “financial buyer” seeking to leverage his/her cash resources into an acquisition of the largest, most profitable business available. The typical financial buyer may possess strong management skills (based on experience in another industry) and have ample funds for working capital and facilitating growth, but he/she lacks the distinct advantages which accrue to an already existing, experienced industry player. Given the technical expertise needed to effectively understand, direct and operate a business such as ABC, the typical financial buyer is unlikely to aggressively pursue an opportunity such as this without a partner with the requisite expertise and licensing capability.
Similarly, this “strategic variant of fair market value” is greater than the probable fair market value to the financial buyer due to the familiarity and stability associated with the collection of favorable operating traits brought to the table by the strategic buyer which normally culminates in a higher purchase offer and a better “price” for the seller.
In order to more fully understand the benefits associated with this variation of fair market value, it is necessary to elaborate on the specific advantages, strengths and opportunities which accrue to this type of buyer in a typical transaction. The precise mixture of beneficial attributes is both “deal-specific” and “buyer-specific”, but it is possible to consider this type of buyer in the form of an “amalgam” of potential strategic buyers” as should be the case with fair market value applications.
According to Ms. Catherine H. Cloudman, CPA/ABV of Couldhawk Management Consultants, LLC (merger and acquisition advisory firm):
“Strategic buyers will typically bring a wide range of synergies to the table and are usually motivated to buy because of the operational fit between the two companies. The synergies range from cost savings to new channels of distribution to better utilization of the company’s assets. Part of the success of the transaction is linked to making fundamental changes in the way the business operates in order to achieve the synergies identified. Retention of management is often less of a concern with strategic buyers. Typical strategic buyers include competitors, companies that are integrating vertically or horizontally, or roll-up firms. Strategic buyers can often justify paying a higher price for a business.
Financial buyers tend to take a portfolio view and have a higher tolerance for financial risk. They evaluate numerous deals, have specific financial objectives and are disciplined in their approach. They usually look to acquire controlling interests. Financial buyers are apt to be more conservative in terms of evaluating normalizing adjustments. The acquisition criteria of many financial groups include minimum revenue thresholds as well as profitability or cash flow targets. Some groups target industry sectors such as manufacturing or consumer products. Most groups want a commitment from management to participate for some period of time. There are a few groups that seek turnaround situations and, because they possess the operational capabilities, are less concerned about management retention. It is common for financial buyers to have expectations of returns in the 25% to 35% range.
The following table lists several examples of generic “strategic” or “synergistic” benefits as they pertain to this variant of fair market value. Just like many other industries, the design, production, sale and management of pre-packaged software programs are subject to the benefits of volume and economies of scale. Such benefits can be classified into two general categories of “synergies” and “economies of scale”, i.e. the positive outcomes associated with this type of buyer will impact both the “revenues” (quantity and quality) and “expenses”:
Potential Strategic Buyer Benefits
- Diversification of customer and supplier base
- Personnel enhancement, i.e. acquisition of improved skill set (proven software designers, salespeople, office personnel, etc.)
- Additional revenue and profit streams (supplemental or complimentary product or service offerings)
- Potential acquisition of valuable patents, trademarks, relationships, etc.
- Improved access to capital via size
- Higher multiples resulting from higher combined earnings stream (size affect).
Economies of Scale
- Ability to “spread out the overhead”, i.e. lower average costs of production, distribution and service.
- Elimination of certain redundant positions with reduction in operating expenses, e.g. only one President/CEO, one Lead Sales Executive, etc.
- Bulk purchase discounts for equipment, supplies and even advertising
- Reduction of “rent expense per square foot” through consolidation of physical premises
Even the IRS has gone so far as to propose the legitimacy of utilizing the standard of value referred to as “investment value” (in effect the use of fair market value as associated with “strategic buyers”) in tax-related valuations if and when the typical buyer is another similar business operation or another business operation operating in a vertical or horizontal link in the production and distribution chain. The IRS has officially explained this position in their publication of “IRS Business Valuation Guidelines” for use by their internal staff in valuation-related cases. Specifically, paragraph 220.127.116.11 highlights this important consideration:
IRS Business Valuation Guidelines (Section 2.3.6)
2.3.6. As appropriate for the assignment, and if not considered in the process of determining and weighing the indications of value provided by other procedures, the Valuator should separately consider the following factors in reaching a final conclusion of value:
18.104.22.168. Marketability, or lack thereof, considering the nature of the business, business ownership interest or security, the effect of relevant contractual and legal restrictions, and the condition of the markets;
22.214.171.124. Ability of the appraised interest to control the operation, sale, or liquidation of the relevant business;
126.96.36.199. Other levels of value considerations (consistent with the standard of value in Section 188.8.131.52) such as the impact of strategic or synergistic contributions to value; and
184.108.40.206. Such other factors which, in the opinion of the Valuator, are appropriate for consideration.
The implication is that if the “typical, hypothetical, most likely” or “amalgam” buyer is a strategic buyer, then synergistic or strategic contributions to value should be considered. The valuator finds this enlightened and logical from a “real world” valuation perspective. The SBA realm provides another vivid example of the relevance of considering “strategic” benefits when valuing certain types of businesses for purposes of obtaining guaranteed acquisition financing. The SBA policies and procedures include verbiage which in effect stipulates that the determination of fair market value should be based in large part on the unique and situation-specific contributions of the “known” buyer rather than that of a “hypothetical” buyer.
Although not precisely identical to requiring the use of a strategic buyer within the fair market value paradigm, the reality is that the SBA considers the evaluation of “strategic benefits” or any valuation implications associated with the given buyer as a relevant and even required procedure on the part of the appraiser, i.e. to ignore the types of value-enhancing factors associated with a strategic (or known) buyer would be a dereliction of duties based on certain SBA-sanctioned valuation methods published by this important government agency.
In conclusion, the valuator is of the opinion that the most likely buyer for a firm such as ABC would of the strategic variety and capable of enjoying synergistic benefits similar to those introduced earlier. This perspective has been seen by the appraiser in a wide variety of industries ranging from service (real estate brokerages) to high tech (internet service providers) to construction (special trade contractors) and others and within a wide variety of valuation applications.
The preceding analysis has shown that the use of strategic buyers within the fair market value context permeates the valuation world, including but not limited to the following environments:
- Tax-related valuations (IRS Guidelines)
- Court cases (Estate of Mueller v. Commissioner)
- SBA-related acquisition financing valuations
- Transaction realm (appraiser’s experience as a business broker for many years)
- Contractual/Shareholder disputes (as in the current case)
One important aspect of the typical sale of a business to a strategic buyer involves the retention of existing management for a prolonged period of time subsequent to the closing. Such buyers will frequently insist on an employment contract with the seller and key employees in order to effectively transfer the managerial functions to the new owner’s hired personnel. Although the strategic purchaser is likely to bring the requisite skills and licensing capacity to operate a business such as ABC, the benefits of willfully promoting a seamless transition from the perspective of employees and customers are significant and the temporary retention of the departing management via employment contracts is desirable.
These employment contracts are normally at “market wages” for the seller(s) and last for as long as several years. In the case of ABC, a period of one year may prove sufficient for purposes of installing and training replacement personnel for the firm’s key employees.
As discussed at length in the valuation analysis section of the report, there is a well documented, empirically proven and generally accepted belief among the valuation community that there is a “size affect” in relation to the magnitude of a firm’s earnings and the typical multiples that are obtained from the sale of a privately-held company. Specifically, as the amount of earnings rises (however defined), so too will the pertinent typical or average multiple associated with the given type and level of earnings.
The significance of this relationship within the discussion of the standard of value and the typical buyer which will emerge lies in the recognition that the combined earnings of two similarly-sized firms such as ABC will tend to generate a higher multiple of earnings (all other things equal). Stated differently, one of the motivating factors for the strategic buyer is the knowledge that the resulting earnings will collectively be valued at a higher multiple than either of the standalone earnings streams. In effect, the acquiring firm’s earnings will be worth more after a merger/acquisition than prior to a merger/acquisition (ceteris paribus). This phenomenon helps to explain, in part, the reason that strategic buyers will most often pay higher multiples than the typical financial buyer.
Level of Value
As inferred by earlier commentary and analysis involving strategic buyers and fair market value, one of the most important preliminary determinations made by the appraiser concerns the choice of the relevant “standard of value” and “premise of value”. Often intertwined into these two concepts is a related topic known as “level of value”. At this juncture, it is sufficient to recognize that the “level of value” refers to attributes involving the degree of “control” and “marketability” associated with the subject investment.
For example, there is a potentially substantial difference between the valuation of a “control, marketable” interest as opposed to a “non-controlling, non-marketable” interest. In practice, the goal is to ensure that the selected valuation methodologies either produce the proper (corresponding) level of value or that adjustments are made to “equate” the valuation results with the pertinent “level of value”.
The subject assignment involves the valuation of a “control, non-marketable” interest with the “control” element built into the derivation of the benefit stream (includes adjustments that can only be made by a “controlling” shareholder) and with the “lack of marketability” or relative illiquidity (as compared to publicly-traded shares) discount built into the selected valuation methodologies (specifically into the relevant cap rate/multiple). Stated differently, the “control” element is captured in the benefit stream known as “discretionary earnings” and the “illiquidity” is captured in the pretax capitalization rates/multiples applied throughout the ARM Approach.
In general, each specific assignment must be individually assessed in regards to the determination of the appropriate standard, premise and level of value. These findings play a pivotal role in determining which specific valuation methodologies are most pertinent and influence the manner in which the selected methods are utilized and/or adjusted to “match” the relevant valuation environment. The analysis presented earlier concluded that the relevant standard and premise of value was the common “fair market value on a going concern basis” from the perspective of a strategic buyer.
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