Acquisition Marketplace Review - The Journal of Applied M & A Theory

Seven Key Factors That Influence Price Negotiations

Using the Fair Market Valuation and the seller's asking price as a starting point, there are seven critical factors that will influence the premium or discount to be applied in reaching a negotiated purchase price package. These seven factors include:

  1. The type of buyer.
  2. Financial parameters.
  3. The general attractiveness of the company.
  4. The relative negotiation skill and leverage of the parties.
  5. The buyer's experience with prior acquisitions.
  6. The inherent risk factors and the buyer's tolerance for them.
  7. General market and economic conditions and outlook.

I. Type of Buyer:
Not all buyers are created equal. Buyers have different acquisition objectives, growth and competitive pressures, availability of capital and the attendant costs, risk tolerance and adeptness at negotiating deals that impact the amount they might pay for a given company at a given time. The type of buyer you are will impact the price you are willing to pay:

  • Bargain hunters are looking to acquire at the lowest possible price; below market rates. 
  • Financial buyers seek a return on their capital and that return more or less puts a cap on what they can afford. 
  • Corporate and industry buyers are buying for strategic objectives such as obtaining additional capacity, products, expand sales or diversification.  Such buyers are generally willing to consider a premium over market value. 
  • Strategic or synergistic buyers believe that the “synergies” inherent in the deal will allow it to pay an even higher premium that will be justified on the basis of the benefit of the synergies.  If reason is at the helm, synergies will pay for themselves and come from things like revenue enhancement, cost savings, process improvements, and balance sheet composition.  However, paying a significant premium based upon anticipated synergies is a risky proposition.  Higher prices mean lower margins for error and in many cases synergies fail to be realized.

Bargain hunters are likely to favor valuation approaches that look at tangible asset values or historic earnings using a high capitalization rate.  Financial buyers may favor valuation approaches that utilize historic and future earnings.  If the financial buyer is entertaining an LBO, the underlying asset values and debt capacity are also a consideration.  Corporate and industry buyers tend to consider valuation approaches based upon future earnings and market comparables.  Finally, the strategic/synergistic buyer may favor the same valuation methods as the corporate/industry buyer but will factor in a premium for the value of the synergies.

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II.  General Attractiveness of the Company:
Naturally, an asking price that is below market valuations is going to make a company more attractive.  For that matter, an asking price that is in close proximity to the company’s fair market valuation is also attractive. Factors that make a company attractive include: 

  • Quality of earnings.
  • Growth rate higher than industry norms.
  • A strong balance sheet.
  • Capacity to support additional debt.
  • Leadership or dominance in the market.
  • Strong management.

An attractive acquisition candidate encourages a higher premium for two reasons.  First, if the overall economics of the business make it attractive, it’s future earnings can support a higher premium.  Secondly, as a general rule, an attractive acquisition target is going to attract a larger universe of interested buyers.  Given the law of supply and demand, as the universe of interested buyers expands, the pressure increases for a higher premium. 

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III.  Financial Parameters:
The seller’s financial parameters are pretty straightforward: to walk away with the most after-tax dollars.  The seller may have set the negotiation stage with an asking price and may have formed a floor or walk-away price as well.  From the buyer’s side, the financial parameters that determine what can be paid for the company include the following: 

  • Internal cash available for investment in acquisitions.
  • The amount they are willing to invest in a single deal.
  • The cost of capital (actual and calculated).
  • The buyer’s hurdle rate: the percentage required over and above the cost of capital.
  • The availability of capital and the terms under which it is available.
  • The reaction of the capital markets to the proposed acquisition.

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IV.  Relative negotiation skill and bargaining leverage of the parties:
As a buyer, the premium you will need to pay will be influenced by your negotiating skills, bargaining leverage and time constraints.  In negotiation, power is derived from your perceived ability to fulfill needs.  The buyer offers the seller liquidity, personal freedom or the opportunity to further develop the company.  The seller offers the perceived economic advantages of owning the company.  The greatest power possessed by both seller and buyer is to walk away, to end the negotiation process—the power of ”NO!” 

Both buyer and seller will enter the negotiation with a set of expectations and assumptions.  The seller’s expectations will be influenced by the size and attractiveness of the company along with the advice received by I-Bankers and other advisors.  If there are a number of potential suitors for the company, the seller’s will tend to drive a harder bargain.  A good I-Banker working for the seller is going to create a process and negotiating environment that is going to encourage the highest and best offer.  The pressure to “pay top dollar” may be subtle, but it is there. 

As a buyer, you want to manage the seller’s expectations.  On one hand, you want to project yourself as a capable buyer.  On the other hand, you want to make it clear that you are looking for a reasonable and fair purchase price package. 

While “cash is king,” the human touch can and does play a vital role.  A promising acquisition can be derailed by a faux pas or an overly aggressive approach.  You want to sell yourself, your company and your vision of the future.  If you ask questions and listen, the seller may reveal their needs.  With some creative problem solving and salesmanship, you might be able to craft a purchase price package that is acceptable without paying a needlessly high premium. 

Time plays a vital role in acquisition negotiations.  Time can be an ally for one party, an adversary for the other.  If the buyer is under pressure to complete the deal by a given date, there may be a tendency to relax resistance to pricing issues.  On the other hand, if the seller is under a deadline (self-imposed or otherwise), then that creates a willingness to be flexible on price and terms.  In most cases, the buyer and seller will attempt to keep their time constraints confidential as knowledge of them gives a definitive edge to the other side.

  • A high premium compresses time.  The seller can easily agree and will usually be motivated to get the contracts drawn and transaction closed quickly.
  • If the business is burning cash, is under increasing competitive or regulatory pressures or if the seller is facing a deadline, the passage of time puts downward pressure on the premium needed to get the deal done.

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V.  The buyer’s experience with prior acquisitions:
The premium that a buyer is willing to pay is influenced by prior experience.  If the buyer paid a high premium in the past and the acquisition failed to deliver expected benefits, they are going think long and hard before offering an overly generous premium.  The reverse may be just as true.  If the seller has experience in the industry, they may be apt to pay a higher premium because they have a greater degree of comfort with their ability to make the deal pay off. 

Experience within the industry reduces the downward pressure on the premium. The buyer’s prior experience provide him with:

  • An understanding of the relative value of companies in the industry and the drivers that influence value.
  • A deeper understanding of the strengths and weaknesses of the company and how it compares to others in the industry.
  • The existence of procedures and systems to insure a smoother transition and the exploitation of existing opportunities.
  • Knowledge of the industry makes it easier to identify financial shenanigans and separate substance over form.
  • A better understanding of the risks facing similar companies and the industry.

On the flip side, a lack of positive experience in the disciplines of corporate acquisition and post-acquisition integration encourages a lower premium, not because of the company, but because of the buyer’s recognition of a higher probability for a bad outcome. 

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VI.  The inherent risk factors and the buyer’s tolerance for them:
Risk can be defined as the possibility of a bad outcome or, stated another way, the uncertainty of a desired outcome.  Tolerance of risk is your willingness to accept and manage the risks.  Risk management is the action that you take to reduce the possibilities of a bad outcome and increase the odds of a desired outcome.  When it comes to negotiating the purchase price package, the biggest risk is that you will agree to a purchase price package that does not make economic sense—overpaying! 

When it comes to the risk of acquisition pricing, there are two key principles:

  • The lower the inherent risks of owning the company, the higher the premium a buyer might pay.
  • The higher the premium paid, the greater the risk.

The evaluation and due-diligence process should address these and all other inherent risks: 

  • Key customer dependency.
  • Key employee dependency.
  • Market uncertainty or growing competition.
  • Weakness in the supply chain.
  • Existing or pending litigation.
  • Existing or pending governmental regulation.

If a buyer wants to acquire a company, there are two avenues to a higher return:  

  • Pay less for the company.
  • Implement a plan to increase the company’s earnings once the transaction is closed.

When banking on increased earnings to justify a higher premium, keep in mind that the greater the number of positive outcomes assumed, the greater the odds of an undesirable outcome. 

Once you identify the risks, the next step is to determine if can you tolerate them.  If the rewards are sufficient and confidence (not overconfidence) in a positive outcome is high, it may all be worth the risk.  Ideally, the risk should be quantified.  In a potential worst-case scenario, a buyer might pay an exceedingly generous premium and find that anticipated synergies are just not there.  In that case, they may find themselves divesting the company for a price closer to the fair market value.  In such a case, the risk is the spread between the offered price and fair market value.

Obviously, if you are betting the farm on an acquisition and paying top dollar, you are placing the parent in a very risky position.  A failure can have a potentially crushing impact on the parent and its shareholders.  Conversely, the larger the buyer’s overall capitalization and liquidity in proportion to the transaction, the more tolerable the risk.  In this case, the cost of failure, while distasteful, can be tolerated with little impact on the parent and shareholders.

Finally, the purchase price package and the manner in which the transaction is funded are going to place additional demands upon the company’s cash flow.  Such additional demands on cash flow impact the company’s liquidity, working capital and ability to obtain future financing, result in an additional risk. 

The seller’s tolerance for risk could be reflected in a willingness to accept stock, un-rated paper or earn-out and contingency agreements.  

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VII.  General market and economic conditions and outlook:
Economic and market conditions strongly influence the buying decisions of both corporate decision makers and consumers.  The impact on the bottom line can be profound. 

In boom times, making money can be like shooting fish in a barrel.  Expansion capital is available, lenders are willing to say yes, consumers are feeling confident and have money to spend on your products or services, CEO’s and CFO’s are approving all kinds of spending requests.  Some things to keep in mind include:

  • Favorable economic conditions and a growing market can disguise problems with the company that will not surface until such conditions contract.
  • The favorable economic conditions will likely lead to higher earnings, a higher fair market valuation, and higher seller expectations.
  • Your view of the future determines how much of a premium you might offer.
  • Your view of the future is probably wrong.

While favorable economic condition encourage higher premiums, it’s important to recognize that such conditions are usually temporary.  The more dependent you are upon such favorable externals, the greater your risk of reaching the point where you feel squeezed by lower margins and the premium you paid (and wished you hadn’t) when times were good.  Remember, almost every I-Banker in the country is telling their clients that the best time to sell is when the company has reached its peak!

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Robert Machiz
MoneySoft, Inc.

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