1. Merger and acquisition transaction prices may be representative of fair market value, investment value, or somewhere in between. At one end of the spectrum, a sale to a pure financial buyer (one who is buying strictly for a return on investment from the company as a stand-alone entity) usually would be representative of fair market value, although even financial buyers may have some special motivations<br />and advantages. Furthermore, they may have to compete with strategic buyers. At the other end of the spectrum, the more unique the synergies between the acquirer and the target, the more the transaction is representative of investment value rather than fair market value, because the pricing may reflect the synergistic benefits to a particular buyer rather than the price a hypothetical buyer would pay (as<br />required in the definition of fair market value <br />The same acquisition target will have different values to different buyers, due both to perception and reality. Potential buyers will have different views on: (1) the expected financial performance of the target; (2) what can be done to enhance performance; and (3) the risk of deviation from expected results. Certain potential buyers, regardless of their perception of the future, may have a true economic advantage over others. This could be due to tax factors (such as ability to utilize net operating loss carry forwards), potential economies of scale, or opportunities to achieve synergies. Economic benefits which may result from the combination of two going concerns would not, for instance, be available to a so-called financial buyer, such as a leveraged buyout firm. Unless a company is purchased for immediate resale, as in a “bust-up” acquisition, the potential acquiror’s first step must be a determination of what the target is worth specifically to it, not others—and this requires a careful and honest assessment of what the acquiror can do with the combined company.2<br />Quantity and Quality of Data Available <br />Some industries are characterized by lots of acquisition activity while others are not. Even one good transaction generally is better than nothing, if it is a reasonably good guideline transaction and the data are complete and reliable. We generally would want to see at least a few transactions, however, if we were to weight the guideline merged and acquired company method heavily in the final analysis. If the target(s) were public, generally adequate data are available. On the other hand, if the target(s) were private, good, verifiable data may be limited. If the private company is acquired by a public company in a transaction, that might be material to the public company, the buyer discloses the transaction by filing Form 8-K. Reported purchase prices may not reflect considerations such as covenants not to compete or employment contracts. It is often difficult to determine exactly what assets were included in the purchase price or what liabilities were assumed. It is often difficult to get any reliable data on profitability. All of these problems must be factored into the decision whether to use private company acquisition data and, if so, the weight to be accorded to it in the final analysis.<br />Control Transaction (Acquisition) Valuation Multiples<br />When valuing a controlling ownership interest, the analyst often focuses on guidance from other controlling interest transactions (mergers and acquisitions). Control transaction valuation analysis typically focuses on market value of invested capital (MVIC, as defined in Chapter 11) or on aggregate consideration, defined 2William D. Rifkin, “Valuing and Pricing Mergers and Acquisitions I: Concepts and Mechanisms,” Chapter 3 in Mergers, Acquisitions, and Leveraged Buyouts, Robert Lawrence Kuhn, ed. (New York: McGraw-Hill, 1990), p. 39. Reprinted with permission. 12 / Market Approach: Guideline Merged and Acquired Company Method 313 as “purchase price of equity plus total debt less cash.”3 This is common sense, since the control owner has the power to change the capital structure, and control buyers very frequently do. This, of course, means that all the returns available to both equity and debt should be included in the denominator when computing the pricing multiple. Control transaction valuation multiples (often called deal multiples or acquisition multiples) often use the following measures of returns in the denominator:<br />• Revenues<br />• Operating income available to invested capital (earnings before interest and taxes [EBIT])<br />• Operating cash flow available to invested capital (EBIT plus depreciation, and amortization [EBITDA])<br />• Tangible book value<br />• Discretionary earnings (also called seller’s discretionary cash flow, defined as EBIT plus all noncash charges plus all compensation and benefits for one owner operator, used primarily for smaller businesses with heavy owner/manager involvement) Nonoperating income, expenses, and the assets and/or liabilities that produce them are treated separately if they are significant.<br />Announcement versus Closing Date Value <br />There are two important dates involving price discovery in connection with an acquisition. The first is the announcement date. The second is the closing date. These dates can be months apart and there may be a difference between the indicated deal values on the two dates. For instance, if a publicly traded acquirer is paying for the deal with its own shares, the value of these shares may change between the two dates and the agreed exchange ratio may not adjust fully to account for the change. Which price should be used for determining the deal value? Also, should we develop multiples based on trailing earnings as of the announcement date, or as of the closing date? It generally does not make a material difference which date is used. The most common approach is to develop multiples based on the announcement date, following the example of most M&A database services. This gives an indication of what the buyer and seller originally intended to pay or receive for the company, based on financial statements available at the time that the deal was originally analyzed and negotiated.<br />Caveat: Check the Deal Structure<br />Deal Terms<br />For guideline valuation purposes, and certainly if the standard of value is fair market value, it is necessary that the deal price used to develop a valuation multiple be a cash or cash equivalent price. In many acquisitions, the consideration paid is all or partly something other than cash, such as common or preferred stock (sometimes convertible), notes (also sometimes convertible), and so on. The cash valueof such consideration often is less than its face value (rarely more). If using a guideline transaction in which the consideration paid was not all cash, the analyst should make the best possible effort to convert the consideration paid to a cash equivalent value. Exactly What Was Transacted? When using publicly traded guideline company stock transactions, we know that what was sold was stock. When entire companies are sold, however, the deal is often structured as an asset sale. In such instances, it is important to know exactly what assets were sold and what liabilities assumed. In addition to the fact that not everything on the seller’s balance sheet (or off-balance sheet assets or liabilities) may have been included in the transaction, the income tax ramifications of an asset sale usually are considerably different than for a stock sale. Differences in the structure between the guideline transaction and the contemplated subject transaction should be noted and adjusted or accounted for appropriately in developing valuation multiples. This is of particular importance when the guideline transaction was an asset sale instead of a stock sale.<br />Noncompete and Employment or<br />Consulting Agreements<br />Noncompete and employment or consulting agreements are often executed in conjunction with change of control transactions. If these are of significant importance, as for middle-market and smaller company transactions, and available, they should be carefully analyzed for each comparative transaction used. The noncompete or employment agreement usually (although not always) is the property of the individual rather than the selling corporation or partnership. In marital dissolution, dissenting shareholder, and bankruptcy cases, the ownership of noncompete and employment agreements often is an issue.5 If a noncompete agreement is included in a transaction, the value allocated is included in the deal prices found in Pratt’s Stats, Bizcomps, and the Institute of Business Appraisers database. Whereas Bizcomps and the Institute of Business Appraisers database also include the value allocated of an employment agreement, Pratt’s Stats does not. If using multiples for comparative purposes, the multiples shown in the above sources often need to be adjusted if they are to be applied to a valuation where the agreements should not be considered a part of the entity value. <br />Past Subject Company Transactions<br />Past transactions involving the subject company may be fruitful subjects to analyze for guidance as to value. Past Subject Company Changes of Control If the subject company itself has changed control in the last few years, the transaction may be an excellent source of valuation multiples. The valuation multiples used would generally be the same as those discussed earlier. The valuation multiples indicated by the prior transaction may need some adjustment to reflect internal changes in the company or changes in the industry or market conditions.<br />Bona Fide Offers<br />Documentable, arm’s-length, bona fide offers to buy or sell may also be useful evidence of value. Funded bona fide offers (i.e., offers for which the financing for the offer is already in place) should be given more weight and more consideration than unfunded bona fide offers. It is usually difficult, however, to obtain adequate documentation or to verify the arm’s-length relationship of the potential buyer/ seller.<br />Past Acquisitions by the Subject Company<br />If the company has made one or more acquisitions in the last several years, such transactions may prove to be excellent sources of valuation multiples. Again, adjustments may be necessary for changes between the dates of the acquisitions and the relevant valuation date. It may be easy to overlook such acquisitions, because they may not come to light in any of the search procedures normally used to identify merger and acquisition transactions. The subject company may be the only source for such data, but typically is a very comprehensive and reliable source. Therefore, if considering using a merger and acquisition method, it often is a good idea to ask whether the company has made any acquisitions.<br />Formulas or Rules of Thumb<br />Some industries have rules of thumb (sometimes referred to as industry valuation formulas) about how companies in their industry are valued for transfer of controlling ownership interests. On the one hand, if such rules of thumb are widely disseminated and referenced in the industry, they probably should not be ignored. On the other hand, there usually is no credible evidence of how such rules were developed<br />nor how well they actually comport to actual transaction data. Rules of thumb usually are quite simplistic. As such, they obscure much important detail. They fail to differentiate either operating characteristics or assets from one company to another. They also fail to differentiate changes in conditions for companies in various industries from one time period to another. Furthermore, it is common for companies in many industries to sell on terms other than for cash, so the “prices” generated by the rules of thumb often are not cash equivalent values. The terms may vary considerably from one transaction to another, but usually are worth less than cash equivalent value. Rules of thumb,<br />therefore, may tend to overstate a cash equivalent value. Consequently, rules of thumb rarely, if ever, should be used without reference to other, more reliable valuation methods.<br />In an article targeted primarily to valuations for divorce, and still widely quoted after 20 years, Jay Fishman offers the following summary:<br />There are no “quick fixes” to the valuation of closely held entities. It is essential to remember that industry formulas or rules of thumb are commonly not market derived representations of actual transactions. Since most industry formulas or rules of thumb are derived from textbooks, trade publications, verbal representations, or other similar sources of information, they are poor substitutes for the Direct Market Comparison.<br />Nonoperating Assets, Excess Assets, and Asset Deficiencies<br />If the subject company has significant nonoperating assets, excess assets, or asset deficiencies that distinguish it from the guideline companies, adjustments for those items may be appropriate. The same principles apply as were discussed in the previous chapter on the guideline publicly traded company method.<br />Selecting and Weighting Multiples for the Subject Company<br />Based on Guideline Transactions The result of the guideline transaction analysis is an array of pricing multiples for each of several valuation multiples. At this point, it is necessary to again visit the questions of (1) which multiples to use in reaching an indication of value and (2) the relative weight to be accorded to each of the multiples used. Earnings based multiples, such as price to net income, and price to pretax<br />income, are generally considered to provide the best indication of business value. However, as with many valuation topics, there is no unanimity respecting the use and derivation of valuation multiples. Franz Ross in his September 2004 Business Valuation Update article, titled, “Just one thing: the most reliable variable for use in the market approach,”8 makes a case for the use of gross profit multiples. In particular, Mr. Ross notes that the use of pro forma earnings inputs in the market approach often compounds potential errors of omission or commission in developing such pro forma earnings and, as a result, tends to invalidate the use of the market approach as a check on the reasonableness of value indications produced using other approaches. Further, Ross argues that earnings are often subject to<br />manipulation or management, particularly in small, privately held companies, and therefore may not be representative of the potential returns available to an investor in the subject company. Care must be taken by the analyst to ensure that the use of a given valuation multiple is appropriate given the nature of the subject company’s operations, the reliability of the source data, and the apparent market reliance on such data. As a result of this research, Pratt’s Stats added multiples of gross profits to the multiples presented for each transaction reported in the database for each company. For each valuation multiple used, it is also necessary to decide what the pricing multiple for the subject company should be relative to the observed multiples for the guideline transaction companies.<br />Impact of Guideline Transactional Data Evaluation<br />The same general thought processes and decision criteria apply to both (1) deciding on whether or not to rely on any particular valuation multiple at all and (2) deciding on the relative weight to be accorded each valuation multiple ultimately used in reaching the opinion of value. A study of the transactional data may lead to greater or lesser reliance on certain valuation multiples than one might have expected<br />prior to compiling the data.<br /> Number of Data Points Available. <br /> If it turns out that very few data points are available for a particular valuation multiple, that problem may lead one to abandon that multiple or to put relatively little weight on it. This is true even though it might be quite conceptually significant if there were more data. For example, if only two of seven comparative transaction companies had meaningful positive earnings, and thus meaningful price to earnings multiples, the analyst must decide<br />whether the two multiples convey enough information to be accorded weight in the final analysis. Instead, the analyst may, for example, decide instead to use a price to cash flow pricing multiple or a price to some number of years average earnings pricing multiple. Comparability of Data Measurement. Another issue to consider is the extent to which the analyst is satisfied that the adjustments, if any, to the subject company and to the guideline companies’ financial fundamental data for the purpose of presenting the data on a comparative basis. The analyst’s confidence regarding the comparability of fundamental financial data may influence the analyst’s judgment regarding the use of or weight accorded to valuation multiples based on that particular financial variable.<br />Comparability of Data Patterns. <br />Another factor in assessing comparability is the extent to which the data for the subject company “track” with the data for the guideline merged and acquired companies. For example, if the subject company and six of the seven guideline merged and acquired companies had a generally upward earnings trend but one guideline company had a downward trend, the analyst may omit the aberrant company when deciding on appropriate pricing multiples relative to earnings.<br />Apparent Market Reliance. The extent to which the valuation multiples are tightly clustered or widely dispersed tends to indicate the extent to which the market focuses on that particular valuation multiple in pricing companies in the particular industry.<br />Multiple of Stock Value to Asset Value<br />When the analyst has determined that either book value or some adjusted book value figure provides a useful representation of the subject company’s fair market value, the next step is to translate that figure into its implication for the value of the company or interest being valued. This translation usually is made by referring to the relationship of the transactional prices of the guideline companies to their<br />respective underlying net asset values. It may be possible to compute the multiple of market price to book value for a group of guideline transaction companies and to apply a multiple somewhere within the range of such multiples to the subject company book value. If (1) the book values of the subject company and guideline transaction companies were computed on comparable bases, and (2) the asset composition is comparable, this procedure may provide a reasonably realistic estimate for the value of the subject business interest. If using Pratt’s Stats, the analyst may be able to derive a sufficient sample in order to determine a multiple of adjusted asset value, depending on the deals selected and data provided. This can be very useful for asset-intense businesses. If accounting methods for the subject company and for the guideline companies differ significantly, the analyst should make appropriate adjustments before <br />(1) computing the market price to book value multiples and (2) applying them in the subject valuation. There can be additional significant differences, such as in asset mix, that challenge the validity of using one company’s price to book value multiple in valuing another company’s stock. Reaching the Value Conclusion Relative weighting of valuation multiples is similar to that used in the guideline publicly traded company method, except that assets may get a little more weight in a control valuation, since the control owner has discretion over their use or disposition. The same observations apply to nonoperating assets, excess assets, and asset deficiencies. (See Chapter 11, “Market Approach: Guideline Publicly Traded <br />One should recognize, of course, that an actual accomplished merger or acquisition observed in the market usually has been consummated at the highest possible value to the seller, not at some average of possible values. For every such transaction observed, many unsuccessful attempts at transactions were usually made. Furthermore, many transactions reflect some synergistic value, which would contain<br />elements of investment value over and above pure fair market value. All these factors must be considered when deciding on what multiples to apply to the subject transaction, and the relative weight to be accorded to each. Since merger and acquisition value analysis usually focuses on market value of invested capital, the value of the debt must be subtracted to reach the value of equity <br />