Buyers and sellers often have a different perspective relating to the value of a business. Whilst both hope to achieve their desired results, reconciling these value differences is often one of the most challenging aspects of effecting a successful transaction. The sellers of the company seek to maximize the value of the transaction for their shareholders; owners with too high expectations may find themselves unable to sell or merge the company. In transactions, greed is not necessarily good; asking for too much may diminish the potential synergies a buyer may capture in the deal and reduce the return on the transaction to below the acquirer’s hurdle rate of return. The strategic buyers of the company seek to maximize the return on the transaction through the long-term creation of value for shareholders. If the acquirer pays too much for the target company and the synergies never materialize, shareholder value may well be destroyed. Overpaying for a target could have adverse long-term consequences for the value of the company and its shareholders. Thus, it is important for both the buyer and the seller to be familiar with the differences in fair market value and strategic value and how these value estimates play into the negotiations.
Individual buyers of businesses are significantly different than strategic acquirers. Individual buyers are usually looking to “buy a job” for themselves or their family members. Whilst they may be assessing the acquisition in terms of the ability to provide a lifestyle for their family or simply receiving a return on their investment, other non-financial factors often influence individual buyers. For those individuals seeking an investment in a business with a financial return and for those business owners seeking to sell their company, the relevant standard of value for assessing the transaction is Fair Market Value. IRS Revenue Ruling 59-60 of Internal Revenue Code Section 2031 defines Fair Market Value:
[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.
For valuation purposes, fair market value includes several assumptions inherent in the definition. First, property changes hands in an arm’s length transaction between the willing buyer and willing seller. Second, the hypothetical buyer and seller are rational investors. As rational investors, they assess economic and financial factors in relation to the subject interest in order to determine a price at which the transaction will be conducted. Third, the willing buyer is a financial buyer rather than a strategic buyer. A willing buyer does not have synergistic opportunities in the transaction. The willing buyer, then, assesses the transaction only upon the potential for return on invested capital by utilizing a comparable management team.
Given that the willing buyer does not possess any special value-adding factors or synergies that will enhance the value of the business, the fair market value may be lower than the highest price that could be obtained in the market. The fair market value provides the value of the business on a stand-alone basis. To a buyer seeking a financial return only, the fair market value represents the maximum amount that the buyer should paid to acquire control of the future cash flows associated with the business based upon the risk characteristics of the company and the buyers’ required rate of return that reflects the relative level of risk of the cash flows. Fair market value is also the minimum amount that a seller should accept in a transaction. It is easy to see that the actual price at which a transaction is consummated may vary greatly from the fair market value based on the particular situations surrounding the seller and the particular motivations of the buyer. Both buyers and sellers should remember that price is the monetary consideration negotiated between the parties whereas fair market value is a “theoretical” price or standard of value developed by a professional business appraiser that utilizes a number of methodologies and assumptions regarding risk and return for the universe of willing buyers and sellers—not that of particular parties to a transaction.
Unlike stand alone value, which measures the value to the universe of willing buyers, strategic value measures the value to a particular buyer that seeks to capture synergies by combining like operations or complementary operations. The overriding goal of undertaking an acquisition that produces synergies is to create shareholder value of the combined entity that exceeds the value of the individual, stand alone companies. Often times, the seller of a business will retain a certified business appraiser to estimate the stand alone value and advise on a potential transaction. Likewise, an acquirer may conduct in-house analysis regarding the transaction but may also retain a certified business appraiser to develop an indication of the potential strategic value to the acquirer, analyzing and quantifying potential economic, financial, and operational synergies and the probability of realizing those synergies.
In nearly all cases, strategic value produces a higher total transaction value than fair market value. Numerous studies examining empirical data indicate that strategic buyers pay higher multiples for companies than do financial buyers, further illustrating the inherent value of synergies. The following illustration depicts the relationship between fair market value, strategic value, and synergies.
A simple example is the best way to illustrate how synergies impact value and negotiations. This example is for illustrative purposes and does not reflect the entire methodologies and processes used by an appraiser to develop an indication of value.
Highland Global (HG) was engaged to conduct an appraisal of privately-held Berghof Properties, Ltd., a vacation rental management company. HG estimated the fair market value of Berghof on an enterprise basis at $3 million. RLH Investments, a large regional competitor, has been making strategic acquisitions and would like to acquire Berghof. RLH’s investment banker has estimated the strategic value of Berghof at $5 million. The investment banker has identified the existence of four potential synergies and estimated their annual values as follows: lower cost of sales through significant job redundancies ($80,000), lower rent through the elimination of one office building ($50,000), higher revenues through cross marketing ($110,000), and the elimination of corporate management at the target company ($60,000).
The following table provides the calculation of value of each synergy assuming a weighted average cost of capital for RLH of 15% and assuming the synergies are realized in perpetuity.
As seen in the preceding table, the present value of the synergies totals $2 million. Given that HG estimated the value of Berghof at $3 million and the investment bank valued the strategic value at $5 million, the $2 million differential is the value of the synergies. If RLH were to acquire Berghof for $5 million, the net present value of the deal would be $0, as the acquirer would be paying the full present value of the synergies. At a $5 million purchase price, the investment’s internal rate of return would equal the acquirer’s weighted average cost of capital or hurdle rate. Assuming all synergies were realized, the acquisition would neither create nor destroy value for the acquiring firm at a $5 million purchase price.
From a negotiating perspective, RLH would try to avoid paying $5 million for Berghof but would likely see the transaction price fall somewhere in the range of $3 million (fair market value) to under $5 million (full strategic value). The $2 million present value of the synergies provides ample room to negotiate a price that is satisfactory to the seller and allows the buyer to create wealth for its shareholders. If Berghof is acquired for less than $5 million, RLH’s internal rate of return is above its hurdle rate and the net present value of the project is positive; shareholder value is created. At a transaction price in excess of $5 million, the internal rate of return is below the hurdle rate and the net present value of the project is negative; shareholder value is destroyed.
Of course, value is only created if the synergies are actually realized post transaction. If, for example, the synergies realized were only half of those projected, the strategic value would be $1 million lower. Thus, if RLH paid more than $4 million for the transaction, the transaction would destroy shareholder value. If RLH paid less than $4 million to acquire Berghof, shareholder value would have been created. At a $4 million purchase price, no value was created or destroyed.
It should be clear to see how important the estimation of synergies is in determining the strategic value of a company being acquired. Over or underestimating the prospective synergies in an acquisition play a key role in creating or destroying shareholder value. Buyers and sellers should be cognizant of the difference between fair market value and strategic value and how these differing standards of value impact negotiations in mergers and acquisitions. Buyers who do not understand this may engage in transactions that significantly destroy shareholder wealth. Sellers who have exaggerated senses of the value of their company risk turning away potential suitors and, in the process, destroying their own shareholder value. Finally, it is always important to seek the objective advice offered by certified business appraisers in helping develop an indication of value (either fair market value or strategic value) when involved in a merger or acquisition of a company. Failing this, the transaction itself may be doomed to fail on various levels.