Home OPINIONS Private equity tips on valuing a business acquisition

Private equity tips on valuing a business acquisition

There is nothing more subjective than determining the value of a business when making a transaction to acquire it with the buyer pushing for the cheapest price while the seller overestimates its value.

Over the last decades, deal making in East Africa has evolved as local and international private equity (PE) companies midwife small businesses to scale by linking them with much needed capital.

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The rise of venture capitalists has helped unlock immense value by introducing crucial but lacking ingredients that inhibit the growth and development of small and medium enterprises, including capital, management support, environmental consciousness, and good corporate governance practices.

This has mainly been done via either debt or equity.

By providing debt financing from long-term funds of large finance houses, notably development financial institutions, endowment funds and family offices, and putting them into the hands of experienced fund managers, PE helps deploy resources into private enterprises to grow and repay the loans.

The venture capitalist also arrange for investors to have skin in the game, through purchasing a stake or a combination of debt and equity- usually called mezzanine funding.

However, equity investment presents significant challenges, especially for early-stage and family-owned enterprises during acquisition.

Valuation is perhaps the most crucial part of this transaction,brought about by the high degree of conflict between the buyers and the sellers.

A seller, usually a founder, aims to maximise the stake’s price. Given the founders’ long-term effort and sacrifices in establishing their businesses, there is a kind of nostalgia when they must hand that over to other people. It is, therefore, normal for founders to psychologically overvalue the business at times well beyond its realistic or commercial value.

Price is thus the payout the buyer asks, negotiates, or demands, and it is driven by several elements, including emotions, greed, or sentimental attachments to the business they have built over time and can’t let it go easily.

On the other hand, buyers focus on the expected future of the investments. The amount the buyer pays today significantly affects the investment return. The buyer is, therefore, more inclined to the fundamentals of the business and how it can grow and thrive to generate value over time above the price paid out, all in present value terms.

The buyer’s objective in a negotiation is to reduce the payoutas low as possible.any mistakes the buyer makes by overpaying for the business will take a long time to correct and will eventually determine the long-term return on the investment. Simply put, price is what you pay, and value is what you get.

Private equity funds are cautious with this aspect as it determines their reported returns, and this not only affects the ability to raise future funds but also determines the reward paid to the fund manager, which usually only kicks in after they attain a pre-determined hurdle or minimum return relative to the amount of capital invested.

Determining what is referred to as intrinsic value is an established discipline with clear guidelines to ensure that the parties can generally use similar approaches and that any significant differencesin figures arrived at by two valuation expertscan be explained.

The valuation process utilises different variables, makes assumptions about the future cash flows of the business, and discounts these to the present.

This process recognizes the time value of money; in that a shilling received today differs from a shilling received a few years from today.  If the present value of the projected future cash flow is less than the price paid today, the buyer will be worse off by engaging in that transaction.

In projecting future cash flows, the buyer considers the interventions they plan to do to unlock value in the business. The interventions may include strengthening the management team, opening new markets of deeper market penetration, better working capital management, more working capital support, debt, or equity capital injection for capital investment for growth and efficiency improvements.

Even though the valuation process can sound scientific, there are a lot of qualitative considerations that go into the negotiation process.

The buyers should strive for a fair settlement. Any feeling of unfair treatment can be detrimental to the future relationship, especially where the seller only offloaded a partial stake, and both parties have to start working together. A wounded seller can overtly work to sabotage the business post-acquisition.

Failure to commit to further capital injection where desperately needed, bad-mouthing of the new owners, sharing trade secrets, and sheer sabotage are but some revenge that the jilted seller could engage to the detriment of the business.

The buyer should thus fight the temptation to pay the lowest price but strive for a fair deal; in the end, all parties will be winners.

 

Anthony Gichini, CFA, is the investment manager at transcentury plc

Anthony Gichini
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