When evaluating the time value of money, the saying “a bird in the hand is worth two in the bush” rings true. That is, depending on an investment’s risk and payout period, $1 paid out today could be worth more than $2 promised to be paid far in the future.
Wondering how this concept relates to business valuation? It’s important to understand the cash-equivalent value of comparables when the value of a business is based on the sales of comparable companies under the guideline merger and acquisition (M&A) method. Creative deal terms can make a deal more (or less) valuable than it appears on the surface. Here are three common reasons why selling price can be a misleading metric and may require an adjustment to arrive at a cash-equivalent value.
1. Installment contracts
There are some situations where the buyer pays the seller a lump sum up front and then make ongoing installment payments over a period of time (usually, three to five years). Sometimes these deals require interest payments, as if the seller is providing financing for the buyer. Other times, the interest rate is wrapped up in the installment payments and can be imputed based on market rates.
Installment contracts are particularly common among small businesses when a shareholder is settling his or her divorce, or when a controlling shareholder is buying out a minority shareholder. Installment sales are typically used to finance deals when the buyer has limited cash and access to bank loans, possibly due to weak credit, high leverage or insufficient personal assets to guarantee a loan. Because there’s a chance that the buyer may be unable to make timely installment payments, the seller bears additional risk here.
Similarly, if a buyer is skeptical of management’s estimates of future earnings, they may hedge its risk with “earnout” payments. With an earnout, the buyer pays a lump sum down payment, and then the remainder is contingent on the company’s future performance.
If certain benchmarks are reached, the seller may receive the rest of the selling price. These benchmarks could include market share, future revenues or cost synergies. Or the seller may opt to receive a set percentage of, say, the company’s gross receipts or net cash flow for a certain number of years.
It’s very important to define financial terms, payout limits and timing issues upfront because these provisions can get quite complicated. The use of an outside accounting firm can help ensure unbiased financial reporting under U.S. Generally Accepted Accounting Principles (GAAP).
3. Contractual agreements with sellers
Buyers and sellers may enter into a variety of contractual agreements, including noncompetes, consulting agreements and employment contracts. These may, for example, protect the buyer from competition by the seller (for a specific number of years) or ease the transition from the seller’s management style to the buyer’s style.
These contracts are sometimes excluded from the selling prices that are reported in transaction databases. But there are other cases when pieces of a deal are bundled together, and the valuation professional must allocate value to each component of the selling price in order to achieve apples-to-apples comparisons. However, in some industries, a noncompete agreement may be standard, and can’t realistically be separated from the selling price.
A need for adjustment
Because the guideline M&A method is based on real-life transactions, it has intuitive appeal. But experienced valuation professionals know better than to blindly accept comparable deals from transaction databases at face value. It’s critical to understand each deal that’s being used as a comparable. Often, “selling price” includes creative deal structures that may require adjustments. For help understanding how this method works, contact a credentialed valuation expert.