What Are the Differences Between a Valuation and a Deal?

22 Feb What Are the Differences Between a Valuation and a Deal?

 

EPISODE TRANSCRIPT:

SUMMARY KEYWORDS 

valuation, seller, buyer, business, deal, evaluation, firm, enterprise, strategic, oftentimes, strategic buyer, transaction, acquisition, revenue, financial, offer, range, talked, approach, methodology 

SPEAKERS 

Matt Lockhart, Ryan Barnett, Mike Harvath 

 

Mike Harvath  00:05 

Hello, welcome to this week’s shooting Moon Podcast. Broadcasting live and direct from Revenue Rocket world headquarters in Bloomington, Minnesota. Revenue Rocket is the world’s premier M&A strategy advisors to tech enabled services companies. With me today for this week’s podcast and my partners Matt Lockhart and Ryan Bartnerr. Welcome, guys. 

 

Matt Lockhart  00:29 

Good to be here. I was away for an episode or two. And so always good to be back with you guys for the Shoot the Moon podcast. What’s going on, Ryan? What are we talking about today? 

 

Ryan Barnett  00:43 

Well, Matt, I hope that you took advantage of the mandatory powder policy that we have here at Revenue Rocket and your vacation and holidays. But we certainly did miss you. 

 

Matt Lockhart  00:55 

Yes, I did. Ryan’s so happy to report. The powder was light and full of champagne. How’s that? 

 

Ryan Barnett  01:05 

Very jealous. Oh, very good. So today we’re talking about a subject that it’s it’s near and dear to everyone’s heart in as industry and and people who go through an M&A transaction is that we’re trying to bridge the gap between what evaluation is and where a deal might get done. And today, I want to discover and dig into what is a valuation? And how do how does that happen? And then how does that translate into framing up a deal in which all parties align and move forward with the deal? So, Mike, why don’t you get us started, just kind of get us thinking about valuations. And you know, what’s the difference between a valuation and a deal getting done? 

 

Mike Harvath  01:51 

Yeah, for sure. So when you begin to think of a valuation, you know, a valuation is in and I use this term somewhat loosely, a general guidepost for the value of the business based on not only reviewing the historical numbers, but also reviewing the forecast. And there’s so many variables that come into developing a valuation, as much as it’s a fairly scientific process, when you think about how we approach it, much of the forecast, in any forecast, regardless of how rigorous your forecasting methodology is, is a bit of an estimate or a guess. And so, you know, when you begin to do valuation modeling, you oftentimes have to say, well, you know, this is our best guest, so to speak, and how do we best approach it in building this into the valuation but but in short, what happens is, the valuation gives you some idea of the relative value of the business, it gives you an approach to estimate that value. And then assuming that, you know, your, again, your assumptions are correct, you can begin to get in the ballpark of a number, what based on what the business is worth. 

 

Ryan Barnett  03:18 

So I just wrote a very, very basic level, and when we talked about this people are, but Matt, can you just tell us about how valuations in this space are calculated and how firms valued might be found in this tech enabled services business? Yeah, 

 

Matt Lockhart  03:36 

for sure, Ryan. So the most sort of simple and clear guidance is that you start with a multiplier of a firm’s EBIT, da so that’s their trailing 12 EBITA. And, you know, the general guidance around the multiplier is, you know, to be broad, would be, you know, seven times EBIT, all the way up to, you know, teams for the right, you know, strategic fit and, and value. And so, you know, that’s the first place to start, you know, as Mike said, there are you add some science to it by understanding, you know, the discounted cash flow basis of a firm as well as the forecasted, you know, growth and so, you know, those are the three sort of primary factors to arrive at an enterprise value for a firm. Now, different firms within tech enabled services are, you know, have are seen as more attractive and or more valuable Well, because of you know, their specialization could be because of their sort of static standard contracting vehicle, reoccurring revenue versus non recurring revenue. You know, these are some of the things that that get into sort of that next layer layer of science. But then the Think of the non scientific value is and and Mike’s the one who sort of coined this and I, I steal it all the time, the ultimate value is what is agreed upon between a buyer and a seller. And the more strategic in nature for the buyer, oftentimes, the higher the valuation, that that can be found, between that buyer and the seller. By now, I think that that’s an important point that that, you know, that’s the ultimate valuation, because ensuring that you’re within a close enough range on enterprise value, is really the, you know, sort of the Alpha and Omega, to find finding a path to getting a deal done 

 

Mike Harvath  06:17 

Yeah and if I can weigh in here, you know, not to oversimplify the sort of definition of the valuation because there’s certain certain attributes to valuation that are important, like, for example, comparable company analysis or precedent transaction analysis, which, you know, we have the luxury here, revenue rocket of having a broad database of comps, and best way to think about it is, like, if you’re going to do a real estate transaction, oftentimes your real estate is that compared to what other pieces of real estate may have sold nearby you that have similar attributes, that same thing is done as part of a valuation. And it’s, it’s weighed, one of the considerations in sort of balancing the, you know, your trailing 12 months EBITDA, and the risk profile of any discounts to your discounted cash flow, etc. I think the purpose of valuation super important too. And, you know, is it for just, you’re curious, or is it pursuant to a transaction or is it have to do with, you know, maybe a partner buy in for equity, or, you know, all those things sort of met a slightly different number, based on sort of a purpose. And then there’s all kinds of factors like market conditions, and you know, the process, sort of how you how you end up approaching the valuation and competition, and what synergies might occur. And all all these things that I think are important to note. So that versus swagging evaluation, we think it’s always best to go to a firm that has deep history and roots in the industry to do evaluation, one that’s experienced, and frankly, one that does a lot of that every month to get a get credible advice about, you know, what your business might be worth. 

 

Ryan Barnett  08:11 

I would add it to this case, a lot of the things that we talked about are our templates in which we use to to help find or calculate the value of a firm. And in some cases, a deal may be trading at four to five times EBITDA. Sometimes that might be 12, to 15. That is something that really comes down into the deal making process as a seller to go through a valuation as its it can be actually relatively relatively simple, in that if you work with a credible advisor, and you have your financial statements in line, you have your forecast in mind, it can be a process which an advisor should give you an appropriate range of what that the range of the enterprise value to Mike and Matt’s point. And the the really the point of this podcast, that range that valuation is is a starting point for negotiations. And if we start to think about that guidepost being set of a valuation, we can look at what’s next. And that’s a deal getting done. And when we when we think about that, that starts to be getting through the process of an offer on a table, the negotiation of that offer, and then moving through an acceptance of the offer due diligence, a definitive agreements and drafting drafting the they rested needed to get through to the transaction in such so we would think about this and why there could be large differences between these two. Matt Mike, I’d love to just hear you know why? Do you see some differences between a valuation range? And where a deal gets done? Matt, want to maybe get us kicked off some ideas around? Perhaps the market conditions, synergies competitions and such? 

 

Matt Lockhart  10:17 

Yeah. I mean, you know, and we’ve covered this in previous podcasts, I think we have one specifically on, you know, applying structure within a deal, right. So, you know, if they say, say the the agreed upon sort of enterprise value of an opportunity is $10. Right? Yet, the buyer wants to extend payment terms, and or even maybe a better example, the buyer wants to include an earnout as part of the component of that enterprise value, well, then the first thing that you do logically is you say, Well, you know, Mr. Buyer, you are taking some risk or applying putting some risk of that enterprise value on to the seller. And as such, because you are minimizing your risk, and the seller is increasing some risk, well, then you would see an increase of that enterprise value from $10, to something above $10. Because there’s a risk factor in, in arriving at that enterprise value. Another scenario may be the seller says, The, we agree upon the enterprise value of $10. But we want to get paid 100% of that $10 At at at the close of a transaction, well, then they’re completely de risked, right as a seller. And, you know, what typically happens is the agreed upon enterprise value, or the valuation decreases to something less than $10 for the transaction. So sort of the first thing that you start to think about in getting a deal done, once there’s a value range that’s agreed upon is, you know, what is it? What if what if any applicable structure is agreed upon between, you know, the buyer and the seller? So that’s kind of the first step that I’d think about?  

 

Ryan Barnett  12:43 

Mike, can you help usunderstand some of the differences between the buyer types in a scenario? And how that can influence the financial buyer may have a much different view than a strategic buyer. How does that play in compared to the valuation? And again, getting that deal written? 

 

Mike Harvath  13:10 

Yeah, for sure, you know, I think in and I don’t want to oversimplify here, because there’s many sponsored strategic companies that have great, you know, financial sponsors that are partnered with them. And they think and act and operate much like a strategic yet they have the wherewithal of a financial sponsor. But you know, if you wanted to try to simplify it, the short answer is that financial sponsors will typically be very focused on sort of return on investment, IRR, internal rate of return on the investment. So that analysis is very focused on return rates, and maybe less focused on strategic synergies and opportunities to make one plus one equal three, four or five, particularly if you’re being required, acquired or recapitalized as part of a platform becoming a platform investment for which that financial buyer will add additional acquisitions using their money. If it’s a strategic buyer, oftentimes, it’s much more about either an adjacency acquisition, meaning, you know, you have a business that complements the other business, you can cross sell and upsell each other’s customers as an example, but you’re not really competitive. Or it’s a little call line 10 continuation business where, for example, if you’re a managed service provider, or digital transformation type business, or an app implementer that you’re buying from The does pretty much what you do, but maybe in a new geography or focuses on a new area of the market. These strategy synergies oftentimes, are, are very have a lot of value a lot of hidden value in particular. And when you figure that out, you can certainly get to return rates and do some modeling to get your return rates, but it’s less about just, you know, straight line growth, or continuing the momentum of the growth of the business and much more about, you know, one plus one equals three, four or five. Now, these lines are blurry, because there’s more and more consolidation in our space. There’s more and more financial sponsors in our space. There’s people doing, you know, leveraged buyouts that are strategics, that have to certainly have a very keen eye on their return rates. Otherwise, they can’t get the loans or financing support in order to do the acquisition. So there isn’t a one size fits all, I want to kind of warn that. Put that warning out there. But in general, you know, you could think that strategics probably have operator that’s larger than your business, if you’re a seller, who’s looking to do have you be part of the team, and certainly have you in many cases sell in and be part of that combined entity. From a financial sponsor, or financial buyer perspective, it would certainly like to leverage your expertise in heavy selling as well, in most cases, but you’re going to be offering that very different sort of capital environment. One that has a lot of pros, frankly, because you’ll have to, you know, likely be wanting to go do acquisitions and grow the business out only organically and continue growing up that way, but grow through acquisition 

 

Ryan Barnett  16:56 

Yeah that make sense? Make a ton of sense. I’m curious question here. Do you feel that a valuation, at Revenue Rocket, we support buyers and we support sellers? Do you think a valuation should be shared with the sellers? Like, let’s say we’re representing a buyer fit? Is it standard practice to share the valuation with a seller? Or is that something that is proprietary to the buyer? Or is there even a best practices for sharing where a valuation may sit? When it comes up to creating a deal or an offer? Mike or Matt, feel free to jump in here. 

 

Matt Lockhart  17:46 

Well, yeah, I think you’re gonna love this right? This is a perfect, it depends. Situate? Yeah, of course, where if they a seller is is sort of completely, you say it’s their first time and and maybe their expectations or understanding of how, you know, sort of the market arrives at at a at a valuation range. And they have expectations that are well, quite honestly, unrealistic, then, you know, oftentimes it does make sense to, to share the the, the approach to the valuation with that seller in the hopes that you can bring expectations into alignment. And because, you know, again, as I stated it, if, if, if you’re not in close enough range, if you’re not in within the basket, then you know, enough of is going to happen. And you’re attempting to get everybody on the same page. And other cases where, say, a seller is represented by another advisor, and or, you know, that they’ve been through the process before. You know, maybe not, not quite as appropriate. But, you know, again, case by case, there’s not, you know, one one simple answer 

 

Ryan Barnett  19:39 

Mike any thoughts there? 

 

Mike Harvath  19:44 

You know, I would say, you know, echo some of the Matt’s comments, I mean, I think it’s always appropriate to share of value, or range, one that you may have calculated and the justification behind that I With a seller to know that you’re, you know, a market player in the ballpark, I often say that win lose deals never get done. You know, there is a lot of there is a lot of tire kickers or bottom feeders calm once you will, in our industry, and you know, oftentimes if you call a firm out of the blue and say, Hey, we’re interested in buying your firm, this is why, you know, they need to know kind of what market is, and they’ll either go get a valuation of their own right, and we do a lot of those for sellers. Or they’re gonna want to, you know, they trust your approach, they may want to know, kind of what is the range of the valuation you came up with? And what was your methodology? And how did you come to that? And, you know, why is it important? And what structure you’re talking about? And can you share it, and sometimes there’s great credibility and sharing the valuation. Generally, we recommend that you at least talk through the methodology with a seller or a buyer, help them understand how you got to the number, why it’s material, and, frankly, you know, what your, what your motivation is for the offer, and why it works that way. And, you know, you should document the offer, so that people understand it. At the same time, you know, I, I think, you know, a valuation is simply a guide, right? And you have to get to the bottom with the seller of what’s important to them, you know, is it important to them to sell in and roll equity, for example, maybe they want to be an owner of your business. And you’re open to that, as a buyer, are they wanting to cash out completely and exit the business, because that does impact the offer, based on the risk profile, generally will lower the offer, if you’re paying all cash upfront, and they’re exiting, or, you know, maybe there’s some combination of collared seller, not all are other considerations that come into play or, you know, earn out or whatever it might be. And all of those things impact value. So understanding your methodology and talking through the approach has a lot to do with you understanding what motivates the seller, from a transaction, beyond just, hey, we want the highest number possible, right? Because there’s just so many other attributes that come into play here. And having some transparency about how you got to the number and why and justifying the number based on the recommended approach on structure, I think is valuable. You certainly can do that without completely showing the valuation. 

 

Ryan Barnett  22:55 

Yet, it’s a very interesting discussion. And it’s, I think you’re right, across the entire process, there has to be education, for buyers and sellers. I think that’s one of the critical reasons why it helps to have an advisor in line, especially if this is your first time, especially if this is a something that’s new to you. Understanding that there will be a difference between the valuation range and the deal structure, or the could be oftentimes when we see some of the valuations come through, for example, even on our website, revenue rocket.com/valuation-calculator, you can get a an accurate, pretty accurate valuation of your business quickly, that will be fairly close to where a deal may come down. So I think there it’s a great guidepost. And in with the appropriate tools out, there can be something that can give you as a seller, a really good idea or even as a buyer to find a range what might be appropriate to talk about. Last question I had here, I think I’ll throw it over to Matt to start here, but have you seen a case in where a valuation is produced? And then we start to get into due diligence and due diligence starts to change? Perhaps that valuation or range or even deal structure? 

 

Matt Lockhart  24:20 

Yeah, I mean, it certainly can happen. I like to is sort of one of those areas where you’re gonna we often say, get a credible adviser on your team. Because it shouldn’t happen. But but there are certainly times and let’s let’s sort of discount those nefarious buyers that put an initial valuation forward and then attempt to retreat a deal you know, after they’ve gotten into exclusivity that that’s just well, crap, if you will. But there are other scenarios in which something may happen in due diligence, say a multi year contract, you know, goes away, a forecast changes dramatically. There, there appears to be an increased level of of accounts receivable that is at risk. You be there, there’s something that changes the customer mix, customer concentration or et cetera, et cetera. So there are, you know, realistic and real factors, that he can have an impact on evaluation, it shouldn’t be a dramatic and or material impact on evaluation, but it can change it. Again, we don’t see that happen with our clients, because we do a very good job of of evaluating all of the factors that are at play in determining that that valuation that is agreed upon in a letter of intent. 

 

Ryan Barnett  26:18 

Yeah, I think that’s very helpful. And it’s a great point on the Retrade. We do see that they’re, oftentimes when someone comes extremely high above evaluation, and I would recommend sellers get evaluation done as on your business. Buyers are going to do one, it helps to have your own set of ammo on understanding what your firm may be worth. We’ve seen some firms even go to the extreme and have any quality earnings done before having a process. I think that may be overkill, but the evaluation itself is something that can be helpful to our view for discussions as you move forward a lot to kind of summarize what I heard today, if I said, summarize the biggest point A believe it’d be the valuation as a guidepost. But ultimately, a deal is done with a willing buyer and a willing seller. And that can be greatly different than the valuation range, based on a lot of the factors that we talked about here today from market competition to the synergies that you’re finding to, to the strategic fit to the company that can be valued greatly. I heard it’s helpful to get a valuation done from a through a seller and just to understand what that’s worth and understand how that may be used. I heard that there’s some differences between strategic and financial buyers. But as we see more sophisticated financial buyers become more strategic buyers. That difference may be a little different, and financial buyers may be great for companies and getting a higher valuation. Where compared to just strategic buyers alone today. Mike Matt, what closing thoughts do you have on this topic? 

 

Matt Lockhart  28:12 

Well, I think we did a pretty good job Ryan, I will sort of echo one of your recommendations, which is it is a good practice to have a valuation done on your business, regardless of your intentions towards selling the business or exiting the business or it’s just a good practice to have that done on on a somewhat regular basis. My Old Firm, we did it at a minimum once every three years because it was a really good guideposts for us. And it also pointed out some areas or opportunities to do better. So as we talked about what a valuation is, versus a deal. They are different things, but they are intertwined. It’s just something that we really encourage all of our clients to do on a regular basis. So now sort of the only thought that I had. Mike, over to you. 

 

Mike Harvath  29:09 

Thanks, Matt. Well, I think you guys summed it up well. With that. We’ll tie ribbon out for this week, Shoot the Moon podcast, take care and make it a great week.