This post concludes our valuation section with a discussion of business cases. Business cases are by far the more common approach to CTA calculation, as most clients do not have an acquisition pipeline robust enough to warrant the creation of standard TOMs (see June 2018 post). Not surprisingly, the method for developing business cases is determined by the deal rationale, since the underlying objective is to model the cost to achieve the key deal value drivers.
Cost Synergy, Business Cases
If the primary value drivers of your deal result from cost synergies, you might consider a twofold approach. Most cost synergy deals realize much of their value through personnel reductions. If this is applicable ask yourself which of the following applies:
If item 1 applies to your deal, then you may be able to forgo the business case process altogether, or you may be able to streamline the scope of the business cases, and still obtain an accurate estimate of costs to achieve. This is because personnel reduction, absent of dependent integration requirements, can often be easily estimated without the need for business cases. Just ensure that Human Resources is involved, and that the following items are included to the extent applicable:
If item 2 more accurately describes your situation, I recommend creating business cases to support CTA for at least 80% of the total cost synergies included in the deal valuation model.
Besides personnel reduction, the most common areas for cost synergies are:
Of these the first 3 generally contribute the greatest operating (non-personnel) cost synergies and the first 2 also generally have the highest costs to achieve; however, if input cost reduction requires renegotiation of purchasing agreements, this can be time-consuming and costly as well. Whether you decide to do business cases only for the first two, the first three, or all the above is a matter of judgement. Remember, the goal is to get accurate CTA estimates supporting at least 80% of your projected cost savings to substantiate the deal valuation.
Note that if your situation does call for business cases, you will need to provide a framework for analyzing the benefits of personnel reduction. If you are going to account for these benefits with a simple analysis- as described earlier in this chapter- ensure that all operational business cases omit such benefits to avoid double-counting. Alternatively, you can have each functional team coordinate with Human Resources to accurately estimate the personnel reduction benefits and one-time costs to achieve, including these in the functional models. Either approach will work.
Using this layout, a cost synergy initiative business case will usually run from 4 to 10 pages, depending on the level of detail provided. Note that not all initiatives will have new recurring costs, but if a new process or operating model, i.e. outsourcing, is being deployed this will apply and should be included.
Once the business cases are drafted, review them for the following:
I find it is useful to bring the various teams together to discuss their drafts and findings at least once prior to submission of the final cases for review. This simple step often eliminates a great deal of overlap and confusion, while providing the teams with insights and encouraging collaboration. It is perfectly acceptable to begin stress-testing certain assumptions during this interim readout. For example, can teams share resources? Or can resources be procured more affordably if sourced under a shared contract? Can additional savings be realized by breaking dependent tasks down into smaller increments, allowing dependent teams to start more quickly? These early conversations begin to flesh out the TOM realization process and will benefit the team as the planning process develops.
Revenue Synergy Business Cases
For stand-alone or minimal integration transactions with revenue synergy value drivers, costs to achieve should be minimal. After all, the presumption is that you are leaving the target largely as-is, and any revenue benefits are coming from accretion and perhaps organic revenue growth, not from combined operations. These deals will likely not require CTA business cases.
For deals with extra-accretive revenue value drivers, the business cases are more complex. You will need to carefully rationalize your selected TOM to determine the integration initiatives required to achieve the level of joint operations necessary to realize your synergy projections. One useful approach to this is to create a forward-looking joint product roadmap; however, note that detailed competitive information is still likely under gun-jumping restrictions, so you will need to rely on carefully documented assumptions in creating a roadmap that supports your conclusions.
Once the roadmap is prepared, you can then conduct an addressable market analysis, and evaluate your projected share capture. Combined with your pricing assumptions- and a price elasticity analysis-, this approach should substantiate the viability of the revenue synergies in your deal model. At this point you can proceed with the CTA business cases using nearly the same approach as described above for cost synergy value drivers, with a few key differences. The template for an extra-accretive revenue cost-to-achieve business case should include the following:
Note the key differences in the cost and revenue synergy business cases. Cost synergies, and accretive revenue synergies, typically have a defined start date, after which benefits are recurring. Extra-accretive revenue synergies tend to require a ramp-up period, reflecting the gradual release and penetration of joint market offers.
While assumptions are required in all cases, extra-accretive revenue business cases rely on assumptions that are more subjective. As such, it is critical to include a robust analysis of TAM, market share, and pricing to document and substantiate your conclusions. Sensitivity analysis is also more critical for these business cases due to the reliance on these assumptions.
It’s common for deal models to have both revenue and cost synergy projections. In this case, you would simply combine the business case methods above to get total CTA, taking care not to double-count any costs. If using both interim and end-state TOMs, remember to factor in timing.
Business cases are the most common method of analyzing costs to achieve modeled deal synergies. Personnel costs can often be estimated without resorting to the preparation of full business cases; however, if business cases are being prepared while a simpler analysis is being used to calculate personnel reduction savings, take care not to double-count costs and benefits.
Overall, remember that the purpose of including costs to achieve in the deal models is to accurately calculate the return from the transaction, and to validate the deal valuation. This objective should guide you in determining which deal value drivers should have CTA business cases, with the goal being to substantiate at least 80% of the projected deal value.
This month we continue our discussion of whether costs to achieve (CTA) should be included in deal models. In last month’s installment we discussed some of the challenges that arise when these costs are included, as well as a few high-level benefits of doing so. In this month’s installment we will discuss the use of a Target Operating Model approach to determine CTA for inclusion.
A Target Operating Model Approach to CTA Inclusion
If you have been following this blog, you will be familiar with the concept of target operating models and their relationship to deal rationales. (April-November 2018 posts). In short, the deal rationale determines the proper level of integration. Deals where most of the synergies will come from revenue, particularly if the drivers include innovation or creativity, will optimize at lower levels of integration. Deals where cost synergies play a larger part and/or there is a greater degree of overlap between acquirer and target will optimize at higher levels of integration. The target operating model for the deal describes the integrated “5 W’s” or the Who (personnel) will do What (business processes and policies) from Where (geography and facilities) on Which (IT, telephony, networks, etc.) tools, and When (timing).
If you have chosen a minimal integration model, it is likely that most of your deal value drivers come from revenue. In this case you will want to evaluate whether any personnel, facilities, or toolset integration are required to achieve the desired revenue synergies. If the synergies are primarily accretive in nature – or if you are purchasing innovation or R&D-then little integration is needed, and you have chosen the correct TOM. In this instance, you probably don’t miss much by using high-level CTA estimates, and forgoing a more extensive process.
Complementary deals that derive their value from revenue synergies that are not merely accretive, i.e. deals where you expect to combine customer bases, co-develop new offers, or otherwise extensively combine go-to-market operations will require some level of integration to reach synergy realization. Overlapping deals where the value comes from combining operations for cost synergy purposes will require a high degree of integration. Vertical deals will vary, depending on the extent to which integration is required for achievement of your business goals.
Hopefully, you have already thought thru this in your TOM selection and have a “5 W’s” analysis that describes any interim and/or end-state TOMs. In cases such as these, taking the time to prepare a CTA for each integration workstream is well worth the effort. You may learn, for example, that regardless of cost/benefit, additional, ancillary projects are required to achieve your goals due to operational dependencies. This will add to your overall cost of the deal and should be taken into consideration. Or perhaps you learn that certain efforts will take longer than anticipated, lengthening the critical path to synergy realization. Regardless, you can expect the CTA estimation process to generate the following outcomes:
Conclusion, and a Warning
Beware of the temptation to change your TOM based solely on CTA. It is completely appropriate to jettison integration activities that are off the critical path and provide insufficient synergy benefits; however, the deal rationale should still drive the TOM. Remember that we chose the deal rationale because of its alignment with the core business problem we are trying to address; therefore, any TOM changes must be scrutinized to ensure that the deal retains those problem-solving attributes. It seems obvious, but you might be surprised how deal fever can affect reason. What starts out as an overlapping deal with cost synergies can suddenly morph into a stand-alone deal that is done for revenue synergies, which inevitably are only accretive and fail to provide return in excess of the hurdle rate.
Just as there are differing perspectives on which valuation method yields the best results, there are also different perspectives on whether costs to achieve belong in the valuation models. In this post we will present arguments for both inclusion and exclusion of costs to achieve.
Arguments for Excluding CTA
Proponents of glossing over or omitting costs to achieve will point out, often correctly, that accurate estimates of such costs are too difficult to calculate. They also correctly argue that taking time to calculate and include these costs will “bog down” the process, and potentially cause the loss of the deal.
The latter argument has merit. You will spend more time on valuation if you attempt to include realistic CTA; furthermore, if the deal is competitive (meaning there are other interested buyers) you may be including costs that reduce your valuation relative to other bidders. This will almost certainly be true if you are a publicly traded or otherwise highly regulated company with heavy compliance requirements that finds itself bidding against privately held enterprises and/or private equity. If you are assuming a full integration target operating model, your CTA will also certainly be higher than a bidder that plans to leave the acquisition alone, even if they are also including CTA in their models.
What happens, then, is that costs to achieve are commonly either omitted from deal models altogether or else they are vaguely alluded to with some very high-level estimates. Often existing run-rate costs are used, with perhaps a few small one-time cost numbers associated with simple items such as separation costs for redundant staff. Regardless of anticipated post-close target operating model, it has been my experience that full CTA inclusion is uncommon outside of best-in-class acquirers.
Arguments for Including CTA
The most obvious argument for including CTA in the deal models is, of course, to get a better picture of the projected return on the investment. Including these costs, with their anticipated timing, allows you to estimate cash flows, calculate returns, and determine if the fully costed deal clears your internal capital hurdle rate. It also provides some defense against shareholder litigation, showing that you applied sober diligence to your investment of their capital.
But capital stewardship is not the only reason to consider inclusion of CTA. A fully costed estimation process helps to validate your target operating model selection and to also identify key dependencies on your integration critical path while there is still time to consider these factors in your overall evaluation of the deal as a strategic move. It can help set realistic expectations as to the timing of joint operations. The latter may suggest that while an acquisition is appropriate, there is not enough time to adequately integrate in response to a particular market dynamic, indicating that another strategic move is required in the near term.
Since I am a former accountant it probably comes as no surprise that I am a big proponent of including CTA in the deal models whenever feasible. This not only provides the opportunity for better investment evaluation, but also forces the team to slow down enough to consider whether the desired timing of synergy realization is practical and meets the strategic needs of the acquirer.
Last month we discussed the importance of re-grounding ourselves in strategic fundamentals prior to calculating our deal valuation, and we also discussed the EBITDA multiple approach to those calculations. This month we’ll discuss the cash flow approach, as well as a few other considerations for calculating estimated deal value.
Stream of unlevered cash flows
A common valuation approach is to calculate the target company’s projected future cash flows- often over a period of the next 5 to 10 years. The cash flows are usually first “unlevered’, meaning that interest expense is added back for the purpose of valuation. Now it’s time for a trip back to our college finance classes. Don’t worry, we’ll make it quick.
Recall that our basic formula for the present value of something is:
Future value=present value *[ (1+rate)^number of periods]
Present values are calculated using the company’s cost of capital, or the required hurdle rate (as set by leadership/board of directors) if higher. An example assuming a 10 year horizon and 18% hurdle rate:
Note that there are a few wrinkles with this approach. First, we are assuming that our ability to forecast out 10 years is solid. Second, we need a relatively near-term positive cash flow stream to make the calculations useful. Third, we are essentially valuing anything beyond our horizon at zero.
It is in part to address this problem that investment bankers will often convert the net present value to an internal rate of return (IRR). The IRR is a fancy way of saying what hurdle rate would we need to use in the NPV formula to give us a net present value of $0? Once calculated, this IRR rate is then applied to future projected cash flows in the assumption that reinvestment would be available at that rate.
Real-World Example: Bad Sport
I was recently asked to assist a CFO in the preparation of a valuation model for an acquisition. The projected unlevered cash flows, along with forecasted financial statements, had been provided by the investment banking team. The small target company had a single product, which they sold only domestically via their website, at a fixed price of $25. For purposes of this discussion let’s just say that the product was a sporting goods item. Thus, you would only need one of these if you participated in that sport, and even so the useful life should be between 5-10 years once purchased.
In looking at the sales figures, I noticed something didn’t look right. I quickly ran a US population analysis, and did some quick total addressable market calculations. To sum up the results, every man, woman, and child in the United States would have needed to purchase 1.32 of these items every 5 years in order to reach sales numbers in the financial projections.
Obviously, this didn’t seem realistic to me, so I checked in with the bankers. Were prices expected to rise? Were new products on the horizon? Markets being expanded? Distribution increasing? Nope, nope, nope, and nope. They had simply applied the growth rate of the last 2 years to the next 5 years, without taking into account the actual constraints of the market itself!
Bottom line, always check the financial models. Make sure all assumptions are stated, and run market analysis on any projections. Be prepared to explain what market share capture is assumed, and why that is realistic.
This solves one problem but creates a few more. First, there can mathematically be more than one IRR- i.e. more than 1 hurdle rate that causes the net present value of future cash flows to be zero- particularly if cash flows fluctuate between positive and negative values. Second, IRR valuations tend to be on the high side, because they treat investment in the target the same as they would treat putting money in a bank account at that rate of compound interest. Since we know that all companies experience a lifecycle of growth, stabilization, and decline, that is a fairly optimistic viewpoint- particularly in highly competitive industries or those subject to higher than average risks.
Note that all of the methods we have discussed thus far are highly dependent on the company’s results of operations. Normally this is appropriate; however, a lot of time can be saved by taking a closer look at what assets the company may have.
I was recently asked by a small, privately-held company to evaluate a potential acquisition. We had some really good comps to use, which yielded an enterprise value of $7 million for the target. NPV analysis suggested a value of about $6.2 million; however, the company had just achieved profitability, after accumulating over $100 million in losses during prior years. Assuming a 30% tax rate, that means that there could be upwards of $30 million of tax reduction value to the company that acquires this target! This suggests a valuation far beyond what my client could afford, and one that would bear no resemblance to the comps or NPV of cash flows. Luckily, we caught this prior to the CEO calling in the Board to review the acquisition, and he was able to save face!
Most acquirers will study the income and cash flow statements carefully, but remember to also look at the balance sheet, and to consider the actual market value of any tax benefits, real estate, or other assets, getting the appropriate experts in to value these as needed.
This is a good time to mention tax considerations. In general, it is highly critical to have skilled tax personnel involved in the evaluation and calculation of the value of any proposed deal. The example above is just one of many I could name. For instance, I once worked on an acquisition with a value in excess of $15 billion, much of which was actually paid for via careful tax planning regarding the legal entity structure of the deal. On the flip side, I also worked on a deal where tax had been left out of the discussion to date, and we discovered a potential loss of several million in value resulting from ignoring tax considerations in the deal structure. As we discussed in our due diligence chapters, make sure tax is at the table, and that they have sufficient time and funding to avoid any unnecessary value seepage!
There is no “perfect” valuation method. Comparisons rely heavily on the judgement of others, and are often apples to oranges. NPV overlooks the value generated beyond the consideration horizon. IRR tends to over-value the company’s long-term contribution to the bottom line. Both NPV and IRR rely heavily on the ability to accurately estimate the future cash flows, which is no easy task in itself. In mature industries I personally prefer to use the median of at least 7 good comps paired with a 10-year NPV to provide a valuation range, with an understanding that am likely to be looking at lower valuations than my competitors that are using IRR. Overall, remember that more than half of acquisitions have historically failed to deliver on their projected value, so our skepticism bias is certainly warranted.
Deal valuation is something that many executives struggle with, and I probably get more questions on this topic than any other. This is understandable. Acquisitions are big decisions that can make or break an executive’s career. They are often competitive, with multiple bidders. Investment bankers, with their deal experience and complex models, can be somewhat intimidating for many, making it a scary proposition to start questioning their numbers.
It is nevertheless critical to make sure the valuation is calculated properly, thoroughly vetted by management, and well-articulated to the board. The best place to start is to return to the foundational basics we’ve discussed in earlier posts:
While it may seem tedious to keep returning to these B-school basics, it is extremely useful to do so as it helps inoculate against the “deal fever” that so often leads to overpricing and poor investment decisions. Buying a company should be like buying anything else for your business, a new photocopier or another delivery truck. “Will the purchase accomplish our objectives better than another approach or investment” is what you are seeking to answer, and the bias should be towards skepticism and objective logic. And you can tell those scary bankers that I said that!
Re-grounded in the strategic basics, with our “deal fever” booster shot, we can get down to the business of some calculations. Two common methods used to calculate acquisition valuations are comparable multiples and discounted unlevered cash flows. We will discuss multiples here, and cash flow valuation in a future post.
Regardless of what other valuation methods you employ, you will likely need some comparable multiples for your board and/or investors to consider. Multiples are calculated thus:
This gives us an average valuation of 10.6 EBITDA, and a median valuation of 10.0 EBITDA, which when applied to our target’s financial results yields the comparable value.
Real-World Example: Nothing Can Compare
Several years ago a CFO asked me if I could take a look at the valuation model for a proposed deal. I agreed, but immediately ran into some noticeable resistance when I contacted the bankers and requested a copy of the model. When I finally got my hands on a copy, the reason for their hesitation became clear. Their figures showed sales revenue for the proposed target increasing at 6% per annum in perpetuity! Nice, but hardly likely.
I immediately set a meeting with the bankers, and asked them to provide the business operations and market research rationale that indicated the business would grow forever. Not surprisingly, they were unable to provide such analysis. Eventually they admitted that the 6% perpetual growth was simply “the formula we had to put in to get to the multiple a competitor recently sold for”. To make matters even stickier, the same bank was representing a party that would benefit from the higher sales price, so definitely a cagey situation.
Luckily, in the example above we were able to calculate a more realistic projection of the company’s prospects, and narrowly avoided overpaying for a terrible investment. Remember to always check the deal models, and to validate all assumptions!
The problem with multiples is the underlying assumption that all parties were rational actors, and that the amount paid for the company was highly correlated with EBITDA. This is not always the case- in fact many tech and pharma acquisitions are done before there is any profit, and sometimes even before there is revenue! This is also exactly how asset bubbles develop, and I would strongly caution against evaluating deal value based solely on what others have paid. Also, the 10.6x above is not what the deal is worth to us, it is just what we might expect to have to pay. What it is worth is another matter altogether, but we know that because we’ve reviewed our strategy fundamentals. Right?
That said, multiple comparisons do have their uses. First, due to different strategic priorities and deal rationales, it would be reasonable to expect an acquisition to be worth more to certain parties than to others. Considering the median/average values of multiple transactions can help predict the range of values that your competitors might be willing to pay, and (perhaps more importantly) what your investors might be willing to fund. So multiples are a reasonable starting point, but don’t get stuck there.
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