Is Valuation a Concern in the World of Mergers and Acquisitions?
By David McClure, CPA, CFP, PFS
The S&P 500 recently hit an all-time high. Another large bank merger (SunTrust / BB&T) and a wave of IPOs are giving the news media ample headlines. Tesla, Uber, and Lyft are all going public with negative cash flows and no earning power, which causes valuation in the mergers and acquisitions (M & A) world to come into question. Yes, these companies have innovated, but will there ever be any positive return to the shareholders? Iconic brands like GE look more like a mutual fund of individual companies, and less like a manufacturing company generating profits from producing and selling a product. GM is still owned by the US Treasury and does not seem concerned with replacing it as a shareholder or creating value for its owners. With stock values hitting highs, one would think a smart CFO would use this new currency to purchase another company to improve the existing company. Given the recent wave of borrowing money to buy back company stock, does the public market CFO really believe the stock is worth what it trades for? In business school, we learn the purpose of business must be creating a return for the investors. What these companies are returning to the shareholder is puzzling to investors. Wall Street will remain a mystery for most of us for many years to come. However, the typical middle market business owner is more concerned with what happens on Main Street than Wall Street.
On Main Street, the traditional reasons for a merger, like succession planning, geographic market expansion, access to additional capital or specialized knowledge are still the main reasons to consider combining with another firm. Main Street is still using the traditional measures of valuation such as cash flow and earnings projections. The low interest rate environment and the recent increase in economic activity has continued to make valuation an issue by having a positive effect on cash flow. However, the small and medium size M & A deal volume is still very strong. There must be an element of common sense or fear of failure involved in middle market transactions that are absent in public market transactions. Recently, I worked with a business owner who sold his company for less than was available to him, taking the second-best offer. This business transaction reminded me of the non-financial ingredients needed to make a merger successful.
Culture is an important ingredient in any merger of business entities. If the culture doesn’t mesh from the beginning, then things usually never get better. A company’s values, the way it treats its employees, customers, vendors and shareholders is evident in the company culture. As long as both parties feel respected, then the combined culture can create value.
X-factor is another key ingredient to a successful merger. One should ask, “What is the other company offering or bringing to the table in addition to financial assets?” Some of the typical x-factors are a niche, geographic market expansion, specialized knowledge or operating efficiency, new technology or, as in today’s world, good people.
With a true matching of culture and x-factors, a company can create a great home / work environment for its employees, as well as create a product or service its customers truly value. Small business owners are looking for something more than just creating a large business. They usually are looking to solve a business problem or find an environment where the combination of two entities is three (1+1=3) instead of the normal two. Ultimately, creating value for the employee and the customer will return value to the shareholder.
Wall Street may have thrown valuation / price out the window, but on Main Street, rational business owners are still concerned with their business reputation, creating opportunities for their employees and increasing their personal net worth and lifestyles. Getting valuation wrong on Wall Street hurts an anonymous shareholder, while it becomes personal on Main Street. Main Street business owners still seem to be combining businesses for the traditional reasons and maintaining the valuation discipline taught in business school. On Wall Street, valuation is measured against the weakening dollar, euro or some other financial asset. However, on Main Street, it appears rational business owners still value their companies against the gold standard (personal relationship, handshake and reputation). As always, it is important to create a strong team of advisors to help work through the multitude of business issues when considering a merger of businesses. If you are considering a business acquisition, merger, or sale, make sure your trusted advisors are involved early in the process to ensure you are covering all of the angles.