This article, co-authored by Simon Pearson, Anna Faelten and Helen Jones, discusses how investors would typically approach valuation and techniques to optimise pricing once a sale process has begun.
For many founders seeking an exit, valuation is one of the most important factors influencing their decision to sell. But what’s the difference between valuation and pricing?
“Price is what you pay. Value is what you get,” said Warren Buffett.
Buyers will consider valuation using a range of methodologies such as M&A and listed peer multiple analysis, Discounted Cash Flow (DCF) and Leveraged Buyout (LBO). The output of the analysis is a rational approach to reaching a price based on the value to the buyer.
Pricing is what a buyer is willing to pay for an asset which is often not rational and as a result can vary significantly from a technical valuation. Buyers should always stick to their walk-away price based on valuation analysis but often do not.
Key factors impacting buyers’ pricing:
- Level of confidence in an asset
- Potential for upside
- Competition or ‘Buyer fear of missing out’
How do buyers establish confidence in an asset?
Many variables can generate confidence in an asset – some examples are:
- Total Addressable Market (“TAM”): What is the size of the revenue opportunity and how well positioned is the company to capitalise on this? A large and growing TAM supports the potential for revenue growth.
- USPs: What makes the company or solution unique vs. competitors? Could this solution become a market leader? Examples of recent wins against competitors and feedback from customers provide strong evidence of superiority.
- Barriers to entry: How open is the market to new entrants? Are there any disruptors in this market or are we the disruptor? Barriers to entry are typically demonstrated by strong intellectual property and high costs of entry into the market.
- First mover advantage: Does the company have a head start in a market vs. competition? Establishing a brand as a de facto market standard supports future growth.
- Scalability: Has the company got the foundations right to accelerate growth? Consider whether the sales team has the right structure and leaders to grow, consider if the infrastructure and systems are fit to scale, etc.
- Downside protection: High levels of recurring revenue with multi-year contracts are attractive to buyers to minimise downside risk.
A number of software unicorn IPOs in recent years have demonstrated how a strong TAM, first mover advantage and scalability can deliver premium valuations.
Buyers love upside
Pricing can be enhanced significantly by demonstrating revenue growth and margin expansion over and above what is shown in the business plan.
This can take the form of organic or inorganic growth:
- Organic: Are there additional product/solution use cases not in the business plan? Potential to expand into additional geographic markets not included in the business plan? Being able to credibly articulate the strategy and approach to achieving organic growth over and above the business plan will focus buyers on the upside potential.
- Inorganic: Is there a buy and build strategy? Demonstrating a strong pipeline of actionable bolt-on acquisitions will excite buyers. However, the inorganic strategy needs to be credible – demonstrating the management team’s ability to complete and integrate acquisitions is key to getting any value for this strategy – consider completing 1-2 acquisitions pre-sale process to establish this credibility.
- Synergies: Is the buyer a strategic or trade party with potential for cost and revenue synergies? Strategic buyers are typically more confident in identifying and delivering cost synergies (vs. revenue synergies) and therefore achieving some value for such synergies as a seller is possible.
Demonstrating upside potential allows buyers to get more comfortable with their baseline valuation and more willing to stretch to higher pricing.
Scarcity value or Buyer FOMO (fear of missing out) as a result of the threat of competition drives up pricing as buyers aim to outbid one another. Generating sufficient interest in a sale process is key. Having a number of buyers interested in an asset allows M&A advisors to run a more formal and fast paced sale process. Pushing buyers to move quickly and place bids in shorter timeframes means they potentially make less thought-out decisions and are less likely to stick with their original ‘walk-away’ price.
- ‘Walkaway price’: Buyers will determine their maximum price based on rational, technical methods of assessing the value to them.
- Buyer confidence factors: Understand which are relevant to the business and ensure these are emphasised during the sale process and in any M&A marketing documentation.
- Upside: Provider buyers with material to get excited about the upside potential (buy and build strategy, additional organic growth or synergies).
- Competition: Ensure that a range of credible parties participate in the sale process. Once interest from buyers is established, drive the transaction timetable to exacerbate the scarcity value or buyer FOMO.