Formula or Number when Pricing M&A Deals?

Should business sellers use a formula or number when pricing M&A deals? Prospective buyers and sellers each have their own methods, rules, calculations and process for determining prices, values and offer ranges. Offers may be structured as a calculation of past and future earnings. For example, one buyer may value a company on trailing twelve months of say 4 x EBIT while another buyer will say the transaction value is $8m expecting this value to remain unchanged during the due diligence period.

Pros & Cons

Naturally each approach has pros and cons for buyers and sellers as well as potentially different perceptions and biases from their alternate vantages. With a definitive number, each side has a good understanding of how the transaction will be priced and play out. The most recent positive performance may however not be taken into consideration although sensible adjustments can be factored in. If the offer is based on a formula, there are far more unknowns and potential for differences in interpretation. A formula may help the seller if current business performance is strong, but likewise also reduce price. It may however add another point of negotiation and deal complication that could derail the whole deal. Small matters can be greatly amplified during long transaction periods and become unnecessary hurdles.

As an example, the valuation may be based on the trailing twelve months earnings with the calculation to be determined on the month-end prior to closing. As a seller you may plug in your values to determine the likely numerical range only to find that the buyer rejects key adjustments you have included (eg bonuses, travel and “excessive” executive/owner remuneration) resulting in buyer and seller final figures being millions of dollars apart. This can be highly emotional and contentious at a critical time!

A formulaic approach is generally impacted by deal timing and closing dates which can often change. If using a formulaic approach, it is important to sensibly provide for timing and include an adjustment mechanism in the offer. Formulas may also use several years of past performance results as well as future forecasts in determining value, again opening areas for negotiation. How many years of history and future are meaningful, what “weighting” for each year? What costs, investments and staffing levels should the model allow for etc? Valuation models and negotiation points can rapidly expand particularly with parties inexperienced in M&A. Seasoned advisors understand what is typical and generally accepted, where the risks are, focusing attention on matters worth negotiating.

In developing valuations your own formulae and models are quite acceptable but the details need not be shared. The merits of the model and philosophy behind the pricing can however influence negotiations. Fundamental understanding of how pricing has been generated is often shared between buyer and seller but should be kept simple.

Offer Acceptance

A buyer doesn’t have to match another buyer’s offer, accept your model or presented adjustments, or meet your demands on timeline or payment structure in their offer. And, a seller doesn’t have to sell. Every value and formula is negotiable.

The key is to keep the deal simple and in particular to ensure that it is easy to understand by “others” who are not part of the negotiation team and whose view and perception may easily be distorted. The “others” are most often the key decision makers. The “others” have little interest in the finer details of formulaic spreadsheets and extensive models and like easy to understand and simple to explain valuations. They also have preferences for round numbers…

Formula or Number, Ultimately $ Dollars

In negotiations, it is easy to fixate on the numbers however it is important to realise that the structure and deal terms are equally important. There are no hard rules in deal pricing and using a formula or number is highly dependent on each unique business and deal structure. Keep in mind, whether using a formula or number when pricing M&A deals, that ultimately dollars are exchanged and a simple deal structure is reduces deal risks.