New England Biz Law Update
The two owners of a company had a falling out but couldn’t agree on a buyout price. The owner who wanted to stay had no intention of selling the company and was only willing to buy based on the stand-alone value of the company. The owner who wanted to leave pointed out the elevated level of M&A activity in the industry, including bona fide indications of interest in the company at twice the stand-alone value, and was only willing to sell at the M&A price.
Both believed they had identified the fair market value of the company as required by the buy/sell clause of the shareholders’ agreement. For a deal to get done, something had to give.
Fair market value is defined as the cash equivalent price at which property would change hands between hypothetical willing and able buyers and sellers acting at arms’ length in an open and unrestricted market where neither party is under compulsion to transact and both parties have reasonable knowledge of the relevant facts. It excludes buyer-specific synergies but includes synergies available to a typical group of potential buyers. The thing that had to give then was one or the other owner’s perception of the hypothetical buyers.
Potential buyers may be categorized as either “retail” or “institutional.” Non-diversified, individual “retail” buyers don’t have complementary assets that can yield synergistic cash flows, and aren’t reducing risk by expanding scale, diversifying their offerings or adding new territories. As a result, they are incentivized to base their offers on the seller’s standalone expected cash flows and cost of capital. Diversified, pooled capital “institutional” buyers like public companies and private equity firms, on the other hand, may have complementary assets that can yield synergistic cash flows and may be reducing risk by expanding scale, diversifying their offerings, or adding new territories.
Given that an acquisition will be accretive if the return on investment, often measured as the target’s earnings yield, is higher than the weighted average cost of capital used to finance the acquisition, institutional buyers have the flexibility to base their offers on a cost of capital ranging from the seller’s at the high end, yielding a price similar to a retail buyer, to the buyer’s at the low end, yielding a price higher than a retail buyer would otherwise bid. In other words, retail buyers are incentivized to be “financial” buyers while institutional buyers have the flexibility to be financial or “strategic” buyers.
Certain businesses have characteristics that are more likely to result in opportunities for synergies to numerous market participants. These include businesses in industries with many small or mid-sized competitors, revenue streams related to essential demands that are recurring, predictable and recession-resistant, economies of scale that improve cost structures and low capital intensity. Given more opportunities to yield synergistic cash flows, more institutional buyers are likely to be interested.
When an insufficient number of institutional buyers are interested, the most likely market participants are retail buyers who, by definition, lack complementary assets and can’t reduce the risk associated with the target business. As a result, the transaction is more likely to occur at a price that reflects the absence of market participant synergies, because there are none. This was the perspective of the owner who wanted to stay.
However, when a sufficient number of institutional buyers become interested, they become the most likely market participants. Institutional buyers may have complementary assets and may be reducing risk by expanding their scale, diversifying their offerings, or adding new territories. As a result, the transaction is more likely to occur at a price that does reflect market participant synergies. This was the perspective of the owner who wanted to leave. Retail buyers can’t compete with the prices offered in this market without accepting a reward that doesn’t fully compensate them for the risk associated with the acquisition.
As it turns out, the company’s industry has all the characteristics that are more likely to result in opportunities for synergies to numerous market participants and sure enough an elevated level of M&A activity in the industry had existed for years and was generally expected to continue. Consistent with its industry the company also had all these characteristics, and sure enough had received several bona fide indications of interest. As a result, the partner who wanted to leave could make a persuasive case that institutional buyers were the most likely market participants and the fair market value of the company should reflect synergies available by that group.
Chuck Faunce is the Director of Business Valuation & Litigation Support at Gorfine, Schiller & Gardyn, a Sorren company. He has more than 25 years of experience providing clients with valuation consulting services including financial and tax compliance reporting, economic damages analysis and expert testimony and buy and sell side transaction analysis.
