Why Valuations Differ by Buyer
The valuation of a company is driven by projected future cash flows. If that is the case, how can there be such a large range of values for the same company? The answer is that the value of a company is unique to each potential buyer.
The Strictly Financial Buyer
If the acquirer is a pure financial buyer and has no strategic interest in the target company other than the expected future cash flow that it can produce, then valuation is a fairly straightforward exercise.
Of course, this assumes the buyer can accurately project future cash flows of the target company, which isn’t always the case. It also assumes that the buyer is slightly clairvoyant about its future weighted average cost of capital (WACC), more specifically, its cost of equity.
But aside from these assumptions, valuation for a pure financial buyer is not a difficult exercise. Consequently, it is reasonable to expect most offers from financial buyers with little strategic rationale will likely be within a tight valuation range.
The Industry Buyer
If the buyer operates within the same industry or a tangential industry, then the valuation tends to increase due to expected synergies of combining the two companies. I say “expected” because quantifying future synergies adds an additional element of uncertainty in the analysis. Because of these synergies and because, overall, people tend to lean optimistically in their projected synergies, the valuation for an industry buyer is often considerably higher than valuations from pure financial buyers. There may also be a wider range of valuations within this group, depending on the buyers’ various synergy assumptions.
Note, financial buyers can also be industry buyers – for example, a private equity firm that already holds a portfolio company in the same industry as the target company.
The Strategic Buyer
The strategic buyer is the ideal acquirer. The strategic buyer is most often an industry player with a specific strategic rationale for acquiring the target company. For strategics, the main factor in determining the valuation may not be the cash flow that the company produces but the unlocking of value that the target company may create under the ownership of the strategic buyer. The valuation is still based on expected future cash flows, it’s just that the cash flow may be from the opportunities that the target company creates under its new umbrella. Or, the cash flow the company produces may be in the form of cost savings it brings to the larger entity. Or, it may be the value the target brings by being the solution to a much larger problem for the buyer.
A Strategic Buyer Story
I once advised a client whose technology company was well-run and delivered a nice product. Based on the cash flow that the company produced, it would be fairly value around $3 – $4 million. However, the company was approached by a much larger entity who literally had a $1 billion problem that the target company could help solve, or at least significantly accelerate the solution. My client figured this should make his company worth $20 million, considerably higher than the valuation that the company could support as a stand-alone entity. I gave this deal a 3% chance of happening at the time, mostly because of the exceptionally high valuation expectations of the seller. As it turns out, the strategic buyer decided that $20 million was round-off error for their $1 billion problem and, to my surprise, the transaction closed at $20 million. This is an excellent example of a strategic buyer paying well in excess of the stand-alone value of the company because the seller’s company solved a very expensive problem much larger than their own size.