Ask The Expert: How To Price Your Company Acquisition And Find A Buyer
David Liu, managing director and co-head of digital media and Internet investment banking at Jefferies, a division of Leucadia National Corp., has worked on more than 100 technology transactions. We caught up with him to ask his opinion as a banker on how companies should think about pricing themselves during an acquisition and how to approach potential buyers.
You’ve completed over 100 deals and probably worked on many more. What’s the first step you take in helping a company in the sale process?
Before I even start helping a company evaluate the sale option and potentially enter into the time consuming and stressful process I call the “M&A dance”, I ask them to meditate on what they really want? What are your true expectations and what do you really expect out of this? That way, I can help them determine if there is even a possibility for happiness — that magical moment when outcomes exceed expectations.
Why do I go through such pains to determine seller expectations? Because it has a huge impact on the actual M&A process. If you have tremendous expectations for the value of your company, then as you go higher up the mountain of valuation, there are fewer buyer candidates at those levels. The air gets really thin. The number of companies that can truly transact are much fewer and so one needs to think really carefully about the right process. The M&A courtship dance is very different depending on your valuation altitude and at lower levels the process is completely different.
What are the expectations of a seller and how are they determined?
Seller expectations really come down to determining the valuation of their business. Unfortunately, this is a complex question with a lot of nuances behind it. One looks at a lot of data but at the end of they day, it really comes down to a seller looking inside their soul and really asking themselves what are they truly worth? I could give the sellers all the data in the world but it’s useless if they still say, “I’m the Michael Jordan in my space and I should be paid like Michael Jordan.” But often there’s little data to justify that. After all, there can really be only one Michael Jordan, so part of my job is to help them think about something more realistic and equivalent to “Scottie Pippen” money.
This is one of the single most challenging things for a seller to accept: their actual objective value in the market. Why? Because often their reference points for value are skewed by the successful sales they read about in the press and this creates “survivorship bias.” In other words, people are biased into believing that all startups are successful like Tumblr and Instagram because those are the only ones they read about in the media. But they don’t read about the thousands of other similar companies that were less successful. They don’t see all the others that had deals fall apart because they asked for too much or suffered from some delusion of their true worth.
The media in particular skews perceptions with survivorship bias. The massive exits become a reference point for sellers, even though they’re quite rare. A seller may say to themselves “So Tumblr sold for $1 billion but I think I’m way better than them so I should sell for $2 billion!” But don’t get fooled by the media. You really need to be academic about it to establish what you are really objectively worth.
Can you walk me through the steps for a seller. What are the steps to coming up with an estimated valuation?
Determining valuation is the first step (see diagram above) and, as I mentioned before, really informs the right M&A process. In general, there are three valuation benchmarks that are used:
1. M&A Comparables
First, think about M&A comparables. What are other similar companies in the same area and what were they acquired for? Try to get a really big data sample to reduce the noise in “survivorship bias.” So don’t forget to look at others that are both above and below what you think you’re worth. You should always use broad sets of metrics in order to reduce the noise factor and get a wider range of possibilities. These various metrics should be industry specific but typically include multiples of revenue, gross profit, EBITDA, net income or employees.
2. Publicly Traded Company Comparables
Second, look at the public markets to find companies to compare yourself with. The challenge is that the data can be very noisy. Conventional wisdom is with public companies you apply a 15 to 30 percent discount to create private company valuations because these companies are tempered by the harsh cold of the public market and, presumably, the best-of-the-best. They’ve gone through the gauntlet of bankers, lawyers and investors. They may not be the best but they’re near the top. Of course, depending on who you talk to, some people think public companies should get a premium or discount to private companies. A premium could be afforded because of their status as public and top quality. A discount is warranted if they are not as financially attractive (e.g., slower growth or lower margin) than their private counterparts.
3. Discounted Cash Flow Analysis
Next, think about your plan and forward projections. This includes a discounted cash flow (DCF) analysis of net present value or IRR. Some argue (even myself from time-to-time) that DCF analysis isn’t very helpful because it can be manipulated in various ways. I agree but it is still a useful analysis to perform for a couple of reasons: First, it helps sellers understand the key metrics, operating variables or business drivers of value for their business. Second, it is a tool that all potential buyers of your company will use.
Buyers will build their own models regardless of whatever you give them and then they will attribute premiums to your value based on potential synergies with your company. I have found that buyers use many valuation benchmarks but many use DCF as a core part of their analysis. That’s the only way to model synergies.
Every buyer generally does the same fundamental analysis but they may weigh each of these analyses differently – particularly depending on the target company’s stage and the buyer’s inclination to use past, present or future based metrics to determine value. M&A comp valuations are based on past data of acquisitions. Meanwhile, public company or IPO comps are based on current data. DCF is the only future-based valuation and is typically based on a longer term plan like 3 to 5 years. As such, the valuation outputs of each method could vary widely and so one needs to think of valuation much more of an art than science.
By way of example, if a target business has a high traffic base but is low in monetization like Tumblr or Snapchat there are no profit based metrics to justify a multi-billion dollar valuation. So a buyer would need to model their valuation based on traffic numbers, future monetization and thus discounted cash flow. It’s generally very hard to use just M&A or public company comps to justify the valuation when something’s growing that rapidly and so much of the value is on the come.
How does that valuation differ when you deal with talent acquisitions or acqui-hires?
If a buyer considers an acquisition as more akin to a replacement for hiring, then the metrics they may use could be quite different and not based on the analyses we discussed. The latter are based on enterprise values while the former is really a proxy for the cost of hiring an individual. As such, the valuation metrics might be based on revenue per head or the expected cost of a team to develop a product or service. Note that every buyer is different but if they are looking at the target as a potential acquihire, then dissecting comps into a per person metric is another useful benchmark for valuation.
You see people talking about $1 million per head. Is that realistic at all?
As an illustration, some buyers consider $1 million per person a useful starting point for negotiation. That’s admittedly a high price – and actually is usually way above the norm. But one thing to remember is that that $1 million price includes everything – any upfront compensation, salaries over 3 to 4 years, incentives or earn-outs, stock or options and so on. So if you compare that to the cost and resources required to build a substantial team, including hiring, vesting, and so on, that $1 million (or whatever the price is) may not seem so outrageous.
It is also helpful to think about how acquihires fit into the larger mosaic of a company’s acquisition strategy. In my experience, every potential buyer of a company is an aggregation of the classic BCG “2×2” matrix which shows every company as a portfolio of cash cows, stars, dogs and question marks. Effectively what you’re doing when you’re buying companies for strategic reasons is you’re getting more stars. When a company makes an acquihire, it’s generally to augment existing cash cows or try to bolster existing starts or question marks. It’s not as much to plant a flag in a new area and thus it’s unlikely to garner an outsized strategic valuation.
Once you have a sense of valuation, what’s next?
After you get a sense of the range of price you’re willing to accept, you can then figure out the potential buyers worth talking to. In other words, who can actually pay for what you think you’re worth? You can do an analysis of those parties and see who has the business rationale to be willing to buy. Of course, in an ideal world, you want to be talking to the key people in these companies earlier, way before you think about selling. To do this you want to look at their product, technology and market.
After you have the valuation and buyers, what’s next?
Timing. Just like in the stock market, the M&A market is so driven by timing. Who has not only the willingness but also ability to buy now in this environment? Some companies have the willingness and appetite to buy, but not ability to buy – because of another recent acquisition, a sagging stock price or a public relations scandal. Or for example, the CEO has resigned and the company’s doing a CEO search. If you’re talking to that company and the CEO has to approve the deal, the deal may not be done until the new CEO arrives.
As you develop your list of buyers, I like to put them into concentric circles so you ultimately end up with a sweet spot of who form your core target list. It’s really no different from a salesman selling a product, working his/her funnel and determining who they should sell to? Are the buyers in an upgrade cycle or not? Maybe they’re gutting their existing solution and want to replace it with your product. Or do they not have solution? A salesman’s going to come up with a target list. That’s not all that different from M&A. One needs to figure out who pays for what, who needs me, then who wants to talk to me or buy me now.
Once you have these three things, valuation, companies and timing, those should align on a diagram. (See Venn diagram.) You have to have all those items come together for a deal to be successful.
Once you have all those targets, how do you approach buyers?
This is where it gets really fun. Most bankers approach M&A in a cookie-cutter like fashion. As in “I Love Lucy,” companies are like chocolates rolling on a conveyer belt – all generally the same. Personally I think that’s a bad process.
In general, I’ve found the best processes I’ve run have been much more surgical and highly customized. In other words, I try to figure out exactly what that seller or buyer wants. With buyers for example, they often have very different priorities and technology they want. Its hard to know what this looks like but doing homework in this area will pay dividends in the long-run and allow one to focus on the right prospects. With sellers, it takes a lot more work but I believe in looking at every buyer on a highly customized basis. Determine what they are looking for and how your company can best fit with them.