Valuation in M&A Transactions Importance and Issues

1. Valuation in M&A Transactions Importance and Issues N S Kumar & Co Chartered Accountants

3. Indian Laws governing valuation Accounting Standards (AS / IND-AS) SEBI and Stock Exchanges Insolvency and Bankruptcy Code Indirect Tax Companies Act Takeover Regulations FEMA Income Tax Stamp Duty

5. Process flow: M&A

6. Motive behind acquisition also affect valuation

7. Valuation methodologies The First Chicago Method is another method used to value start-ups and high growth firms

9. Valuation – Inherent conflict Buyer always wants to buy at the lowest price possible while the seller wants to sell at the highest price possible. How does one decide what is the best price for a transaction, hence the fair value valuation….. “win-win situation for both the parties buyer and seller”

10. Fair value “…the price at which the property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge or relevant facts.” • There are established precedence for valuation methodologies • Valuer’s role is to incorporate case specific factors and use appropriate methodologies so as to determine a fair value • Give weightages to value arrived at under different methods • Market price method and Earnings methods dominate the valuation methodologies • In case of a merger, the emphasis is on arriving at the relative values of the shares of the merging companies to facilitate determination of the swap ratio • The key issue to be addressed is that of fairness to all shareholders

11. Importance – Fair value Acquisition value = FMV + Premium/(Discount) • Why is it wise to obtain a fair market valuation? • A diligent buyer should know the spread between FMV and the price they are willing to pay • Without a fair market valuation, a buyer has no meaningful benchmark of value other than what they are willing to pay • The spread between the seller's asking price and the fair market valuation serves as a useful reference point for "reality testing" and determining how deep the buyer is going to have to dig to find synergies • It enables buyer to decide the structure of the purchase (100%/deferred buy-out, earn-out clauses, etc.) • It helps buyer to allocate purchases price to various assets • Gives the seller an idea of minimum price that they could expect

12. Control premium • “Beauty lies in the eyes of the beholder; valuation in that of the buyer” • An investor seeking to acquire control of a company is typically willing to pay more than the current market price of the company. Control premium is an amount that a buyer is usually willing to pay over the fair market value of a company to acquire controlling stake in a company • A premium paid, if any, will be specific to the acquirer and the target; actual premiums paid have varied widely • Research has shown that the control premium in India has widely ranged from 30-50% The value of control is the difference between the firm run as is (status quo) and the value of the firm run optimally

13. Synergies • Financial synergies: • Diversification • Cash Slack • Tax Benefits • Debt Capacity • Operating synergies: • Economies of scale • Higher levels of growth Value of synergy = Value of combined firm - Sum of the values of the independent firms

14. Case study: Adidas – Reebok • Adidas acquired Reebok in 2005 • Deal value $ 3.78 billion • Adidas offered ~34% premium over last closing price for Reebok • The footwear market in North America was mainly dominated by Nike • Increased market share and cost cutting through synergies were clear-cut strategies for both Adidas and Reebok

16. Reasons for M&A failures Poor strategic fit:Wide difference in objectives and strategies of the company Poorly managed Integration:Integration is often poorly managed without planning and design. This leads to failure of implementation Incomplete due diligence:Inadequate due diligence can lead to failure of M&A as it is the crux of the entire strategy Overly optimistic:Too optimistic projections about the target company leads to bad decisions and failure of the transaction

17. Beware of thumb rules, Synergy etc. • It is common practice to add arbitrary premiums for brand name, quality of management, control etc. • These premiums will often be backed up by data, studies and services. However, there is enormous sampling bias in the studies and the standard errors in the estimates • If you have done your valuation right, those premiums should already be incorporated in your estimated value. Paying a premium will be double counting • Synergy is created when two firms are combined. Combined firm will be less risky than two individual firms and that you would have lower cost and higher value – which will vary from case to case • Assume that there are potential growth and cost saving synergies in the acquisitions, that would increase the value of the firm • Since synergy requires both the acquiring firm and the target firm’s strengths to be pooled, the acquirer should demand his fair share of that synergy.

18. Biased comparable and exit multiples • Analysis of other acquisitions reveals that buyers are willing to pay 5x, 10x may be even 20x of EBITDA….. Should you also as an acquirer pay the same? • Biased samples yield biased results. Basing what you pay on what other acquirers have paid is a recipe for disaster. • When we use the pricing metrics of other firms in the sector, one may be basing the price he is willing to pay on firms that are not truly comparable. • Investment banker will tell you that acquisitions are accretive. If your PE is 20 and whereas target company’s PE is just 10… you will get jump in earnings per share post acquisition • When we use exit multiples, we are assuming that what the market is paying for comparable companies today is what it will continue to pay in the future.

19. Typical issues while valuing Indian companies • Non-availability of comparable companies/transactions, especially for foreign owned subsidiaries • Limited availability of deal related information for historical transactions • Different interpretation of terminologies. Term “earnings” could refer to net income, net operating cash flow, pre-tax earnings, EBITDA or net free cash flow • Rules of thumb fail to take into account the specific company’s financial performance, which could be above or below industry averages • Personal attachment towards businesses and other factors result in setting of high value expectations by Indian promoters

20. External factors which affect valuation

21. Impact of swap ratio • If the exchange ratio is set too high, there will be a transfer of wealth from the bidding firm’s stockholders to the target firm’s stockholders. • If the exchange ratio is set too low, there will be transfer of wealth from the target firm to the bidding firm’s stockholders.

22. Change in valuations/price

23. Don’t pay for buzz words • Through time, acquirers have always found ways of justifying paying for premiums over estimated value by using buzz words - synergy in the 1980s, strategic considerations in the 1990s and GMV’s/users in current decade • While all of these can have value, the onus to demonstrate the value should be on those pushing for the acquisition Principal behind M&A is “2 + 2 = 5” “Render unto the target firm that which is the target firm’s but not a penny more…”

24. GMV/User based valuations • Facebook bought WhatsApp in October 2014 for $19 billion. • Last valuation at time of Facebook acquisition: $1.6 billion • Valuation increase: 1,118%

26. Conclusion “Valuation is an art, not a science” • Take away: • Be clear on the objective of transaction • Be reasonable on projection • Deal structure • Consider all factors