Valuation & Deal Constraints
BVX® uses a novel and proprietary approach, using logical algorithms and advanced mathematics, to determine business value. The principal BVX® criterion can be summarized as, “The Seller wants the best price for the business and the Buyer is willing to pay the price that meets his/her financial return objectives and meets all his/her financial commitments.” Specifically, this criterion is implemented within BVX® through more detailed assumptions, some of which are:
- Seller wants the maximum price, and
- Seller wants to maximize goodwill allocation to reduce taxes, and
- Buyer wants to achieve a certain minimum ROI, and
- Buyer wants to meet all financial obligations to creditors, and
- Buyer wants to pay proper taxes, and
- Buyer wants to maintain a safety cash reserve at year end, and
- Buyer wants to meet all the cash needs of the operations, and
- Buyer does not want negative cash flow, and
- Buyer does not want to plan for equity infusion after the acquisition, and
- Thee is ample acquisition capital available in the market place and that a Buyer can be found with the necessary equity to complete the acquisition, and
- Buyer wants to maximize bank borrowing and minimize Gap Funding, and
- Buyer can find lenders to finance the Gap Funding or Buyer can negotiate Gap Funding with the Seller through Seller Financing, and
- Buyer wants to first borrow against the A/R, then against the Inventory, then against the Fixed Assets, and
- Buyer is willing to accept negative taxable income as long as the cash flow is not negative (Note: In future versions of BVX®, user will be able to control taxable income), and
- Buyer wants to use excess cash flow to pay down debt as described in paragraph 6.3, and
- Lenders will not refinance the term loans during the planning horizon, etc
BVX® converts all of the above requirements and others into a series of mathematical equations and then through random generators and non-linear programming techniques finds values of output variables that satisfy all these requirements.
The mathematical techniques used to find the optimal solution for the business value could take millions of calculations, requiring from a few seconds to a few minutes.
What is Optimal Business Value?
Commonly known finance theory states, “… the value of the firm is independent of financing…” Such theory and its advancements have been the foundation for corporate valuations; however, the real world has significant deviations from the simplified assumptions used in such theories. BVX® theory is “Value of a firm is the Equilibrium of Price, Terms, and Deal Structure that satisfies the needs of all parties to an M&A transaction.”
BVX®, therefore, is a tool to determine business value in a real world involving many variables, such as:
a) debt with different interest rates,
b) debt with varying principal repayments,
c) tax structuring alternatives,
d) different acquisition methods,
e) various lending restrictions,
f) finite time horizons,
g) capital reinvestment, etc.
BVX® valuation is based on True Cash Flow (TCF) to the shareholder. TCF is not the “generated” cash flow; it is not the “available” cash flow. It is the cash flow “distributed” to the shareholder. Most of the M&A transactions are leveraged transactions with distribution restrictions, future borrowing restrictions, management compensation restrictions, etc., imposed by the lenders and others. Buyers, therefore, determine the value of the business based on the amount of cash distributed to them from the business during the planning horizon and the amount of cash that they would receive at the end of the planning horizon as if the business were sold at that time.
BVX® determines the optimal business value by satisfying the cash requirements of the five claim holders to the business cash flow. These claim holders are:
a) the Seller,
b) the Buyer,
c) the Business,
d) the Lenders, and
e) the Tax Authority.
Insights from BVX
In BVX®, value of the business consists of not just the Price (i.e., the amount to be paid for the business) but also the associated Terms and the Deal Structure. BVX® determines one single maximum value for the business associated with the proposed deal structure, payment terms, and the operating assumptions. According to the BVX® approach, different values for a business can exist because of different operating assumptions, deal structures, payment terms, etc., not due to use of different valuation methods.
A few of the value drivers in BVX® are:
- Future Performance
- Financial Leverage
- Financial Return Expectation
- Cash Flow, Not Profits
- Deal Structure
- Asset Type
- Exit Strategy
These value drivers impact business value in many different ways as explained below:
1. Future Performance
Value of a business is dependent on its future performance, not on the past performance. History of the business is relevant to the extent it helps project the expected future performance in the hands of a new Buyer. Future performance of the business depends upon the current condition of the business and what the new Buyer can and/or wants do with the business. Therefore, value of a business will change depending upon the Buyer.
2. Financial Leverage
Value of a business is dependent on the post-acquisition financial leverage. Higher financial leverage, generally associated with high asset base, means lower average cost of capital and hence higher value. A business with low financial leverage (generally associated with a low asset base, or an asset base with low borrowing capacity, or a tight lending market) will command a lower price due to lack of lower cost borrowing. Such businesses can command a respectable price if a cash flow lender can be found, or if the Seller is willing to finance the transaction. Financial leverage depends on the value of the assets, type of assets, size of the business, market conditions, credit worthiness of the Buyer, quality of earnings, post-acquisition management, etc.
3. Financial Return Expectation
Value of a business is dependent on the Buyer’s expected financial return. The higher the Return On Investment (ROI) expectation of the Buyer, the lower the business value. Some of the factors increasing the Buyer’s ROI expectation, and hence decreasing business value, are poor quality financials, up/down sales history, unpredictable and/or uncontrollable profit margins, lack of management, narrow product line or customer base, concentration of customers, suppliers, distribution channels, etc. ROI expectations also depend upon the type of assets; for example, ROI expectations of a real estate property are lower than that for a business property.
4. Cash Flow, Not Profits
Value of a business is dependent on cash flow, not profits. A business whose fixed assets base is high and/or requires high working capital is likely to require more of the profits to be reinvested back in the business, thus reducing the cash available for debt service. Hence, it would be valued lower. The opposite is true for a business with a low fixed assets base and/or with low working capital requirements; such businesses will be valued higher due to low reinvestment needs. (Note: A high assets business increases valuation because it provides more financial leverage, but at the same time it lowers valuation because the higher asset base generally requires higher reinvestment of profits.)
5. Deal Structure
Value of a business is dependent on the deal structure. Deal structure changes the taxes and the debt service of the transaction. In most cases, a Stock Purchase price is going to be lower than the Asset Purchase price due to tax benefits of asset-step up and tax-deductibility of goodwill. Similarly, “all cash” value is going to be lower than the one with Gap Funding (often termed Seller Financing) due to higher cost of capital associated with equity.
6. Asset Type
Value of a business depends on the type of assets used in the business. The type of assets impacts lender advance rates and the depreciation life of the assets, which in turn impacts value of the business. Low working capital advance rate from the lender means more cash is being used up in funding working capital (net of borrowing); hence, less cash is available to the shareholder. Inventory intensive businesses, like distribution businesses, could have lower valuation because inventory has usually lower advance rates from the lender. Businesses with stretched Accounts Receivable (A/R), like health care industry suppliers, or businesses with poor quality A/R, like construction businesses, could have lower advance rates and hence lower valuations. Business requiring capital expenditures for long-life fixed assets will have lower tax benefits of depreciation in the early years; hence, they may have a lower business value. Process industry businesses and businesses with leasehold improvements have a long depreciation life of the fixed assets that negatively impact business value due to the depreciation factor.
7. Exit Strategy
Value of the business depends on the exit strategy of the Buyer. A component of the cash flow to the Buyer is the amount that would be realized at the end of the planning horizon as if the business were sold at that time. Therefore, the value of the business today depends on the value of the business at the end of the planing horizon. Most Buyers make the assumption that the Exit Price Multiple (EM) will be the same as the Purchase Price Multiple (PM). However, many Buyers assume EM to be higher than the PM if they are consolidating an industry or are planning to go public. Similarly, a Buyer may assume a lower EM than the PM if the growth beyond the planning horizon is going to be lower than the growth during the planning horizon.