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Understanding Investment Value and Synergies in a Sale


When it comes to selling a business, the big question in the owner’s mind is simple: “What’s it worth?” And as any valuation professional will tell you, the answer is, “Whatever the buyer will pay for it.”

Of course, this type of exchange is frustrating for a business owner seeking quick, hard-number guidance on value. But it’s important to remember that value is a somewhat imprecise term. Value depends on the circumstances surrounding the business, its cash flow, financial position, competitive situation, management team and many other factors. 

And in every case, value also depends on the buyer’s goals and what the business can provide for that individual or entity. 

Standards of Value

Valuations done for the purposes of transactions are generally based on fair market value (FMV). As a reminder, fair market value is defined by IRS Revenue Ruling 59-60 as “the amount at which the property would exchange hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”

FMV doesn’t assume a specific buyer: It assumes a market of buyers. And while FMV is perhaps the most common standard of value, it is not the only one. For example, fair value is often used in cases of minority shareholder disputes, and intrinsic value is often used relative to the valuation of option pricing. 

The standard of value of interest to many buyers and sellers — even if they don’t know it by name — is investment value. Unlike FMV, investment value is defined as the value to a particular investor. 

In other words, while FMV is what valuation guru Shannon Pratt describes as “impartial and detached,” investment value represents value based on individual investment requirements and expected earnings and monetary return to that specific investor.

It would be rare for a valuation professional to issue a formal valuation report for a transaction based on investment value. However, this is often how sellers envision the value of their businesses — in a sale to a specific buyer who will pay more than FMV due to how much the company will enhance the buyer’s income or existing portfolio.

Synergy Doesn’t Change FMV

According to Pratt, investment value is often different from fair market value for one of four reasons:

  1. Differences in assessments of future earning power.
  2. Differences in perception of the degree of risk.
  3. Differences in tax status.
  4. Synergies with other operations owned or controlled.

While the first three reasons are often relatively straightforward for valuation analysts to assess and quantify, the fourth reason is a bit more elusive in terms of dollar amount. 

Synergies — or a synergistic value — assumes that the acquisition target will complement and augment an existing business enough to justify a price that’s higher than fair market value. The idea is that with a synergistic acquisition, competitors or companies in the same industry may be able to fill a desired product or service niche, sales channel or market void, or leverage existing research and development.

The problem is that synergies are often overvalued — most often by the seller but sometimes also by the buyer. And synergy doesn’t change FMV. While the seller may have better luck negotiating a slightly higher value if there are synergies involved — and should certainly play up synergies in the sales pitch — synergies typically don’t change the valuation landscape to the extent the seller anticipates or desires.

Getting Real About Synergies

To arrive a synergistic value, a typical valuation practice would be to build the synergies into a discounted cash flow (DCF) analysis. This would consider the cash flows the target company would provide for a typical (non-synergistic) buyer versus a synergistic buyer and project a price from those calculations.

But some analysts believe that this methodology is flawed because it tends to overestimate the synergistic cash flows and underestimate the risks involved. Also, it often misses the mark on the division of value between the seller and the buyer.

One solution to this problem is undertaking two separate valuations. The first would be a typical FMV/DCF valuation based on cash flows to a typical buyer. The second would be a separate valuation of the synergies and the discounted cash flows associated with them. The second valuation would generally have a higher discount rate to reflect the higher risk of actualizing the value of the synergies after acquisition. 

Note that the valuation of the synergies involves several fine points. For example, adjustments must be made to the cash flows associated with acquiring or paying the salaries of a full management team, which may or may not be necessary with a synergistic buyer. 

After all of these adjustments are made, adding the synergy value to the FMV will generally result in a more reasonable picture of the synergistic deal. 

Selling and Buying Strategically

If you are considering a sale to a synergistic buyer, it’s important to realistically discuss with your financial advisors and valuation professionals the potentially higher value the synergies might deliver to a specific buyer or set of buyers. It’s also crucial that you refine the presentation of your company to showcase those synergies and how they make your company more valuable.

Of course, if you are on the other side of the deal — as a buyer — it’s imperative that you carefully consider the synergies you envision and realistically estimate the time it will take you to realize the additional value. It often takes much longer than initially expected to fully integrate the acquired company’s assets, operations and sales efforts in a way that fully exploits the synergies you’ve paid for.

Our valuation team is well versed in the ins and outs of synergistic value. Contact our litigation support team today to discuss your specific questions.


Seller Beware

For many sellers, a synergistic sale sounds like a dream. But seller beware: There may be downsides, especially if you are the least bit sentimental about your company. 

For example, the buyer may consider the transaction to be more “strategic” than “synergistic,” and purposefully kill the acquired company (your baby!) to eliminate the competition. Also, due diligence required at the front end of the deal — even under a confidentiality agreement — means that you are disclosing all of your secrets to a potential competitor. 

Either of these scenarios may be unacceptable to you as a seller, so keep them in mind if you are pursuing a synergistic sale. 

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