Valuation of the Target Company
In order to prepare an appropriate bid in the mergers and acquisition process, the buyer must be able to accurately value the target company. This valuation process is referred to as due diligence. Due diligence can be defined as the examination of a potential target for merger, acquisition, privatization, or a similar corporate finance transaction– normally by a buyer. Due diligence involves a reasonable investigation focusing on material future matters and the asking of certain key questions, including how do we buy, how do we structure the acquisition, and how much do we pay? Moreover, due diligence is an investigation on the current practices of process and policies and an examination aiming to make an acquisition decision via the principles of valuation and shareholder value analysis. The due diligence process framework can be divided into nine distinct areas:
- Compatibility audit: This deals with the strategic components of the transaction and, in particular, the need to add shareholder value.
- Financial audit.
- Macro-environment audit.
- Legal/environmental audit.
- Marketing audit.
- Production audit.
- Management audit.
- Information systems audit.
- Reconciliation audit: This links/consolidates other audit areas together via a formal valuation in order to test whether shareholder value will be added.
In business transactions, the due diligence process varies for different types of companies. Areas of concern other than the ones listed above include intellectual property, real and personal property, insurance and liability coverage, debt instrument review, employee benefits and labor matters, immigration, and international transactions.
WIPO Headquarters in Geneva
Intellectual property is an asset of a business that must be included in the overall business evaluation. This photo is of the headquarters of the World Intellectual Property Organization in Geneva, Switzerland.
It is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process. This is in order to reduce the number of failed mergers and acquisitions. The five most common methods of valuation are:
- Asset valuation
- Historical earnings valuation
- Future maintainable earnings valuation
- Relative valuation (or comparable transactions)
- Discounted cash flow valuation
Professionals who value businesses generally do not use just one of these methods, but a combination of them, in order to obtain a more accurate value. As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right. Synergies are different from the "sales price" valuation of the firm, as they will accrue to the buyer. Hence, the analysis should be done from the acquiring firm's point of view. Synergy creating investments are started by the choice of the acquirer and, therefore, they are not obligatory, making them real options in essence.