Valuing Synergies - O'Keeffe and O'Malley

Valuing Synergies

Oct 03, 2014

Many factors should be considered when determining the value of a business. One important factor is valuing synergies. A business that can demonstrate capability in providing enhanced economic benefits to a particular buyer increases its value. The strategic buyer may be willing to pay a premium over the fair market value of a target company when recognizing how the two entities can be combined to create a new and more valuable entity.

Two primary benefits, or synergies, that a potential transaction can provide are: increased revenues and cost savings.

Revenue Increases

When two companies are merged, opportunities to increase sales may occur. For instance, larger entities can take advantage of the acquired customer relationships and offer expanded product lines or move into new markets. In addition, eliminating a competitor by acquisition may allow the company to charge higher prices. However, quantifying the potential increase in revenues is difficult because the assumptions, although reasonable and based on the best information available, are still subject to factors outside management’s control. Consider allocating part of the value on an earn-out or contingency basis.

Cost Savings

The most common type of synergy is the potential savings in costs. This type of synergy is also easier to quantify. Combining two businesses often allows the merged company to operate with lower combined costs. For instance, the new company may be able to operate with fewer administrative employees. In addition, the combined company may be able to achieve additional cost savings through greater bargaining power with suppliers, resulting in lower material costs.

In some cases, a poorly run company may offer the buyer opportunities to increase efficiency and eliminate waste. If a buyer expects to improve a company’s operations after the acquisition, increases in shareholder value should reasonably occur beyond the current market value.

Transaction Type

The type of transaction will impact whether, and to what extent, the new company will benefit from synergies. Generally, merger and acquisition transactions can be classified into four types:

1. Horizontal: Companies operate in the same line of business.

2. Vertical: Companies in a vertical transaction make products at different stages of an industry’s supply chain.

3. Congeneric: Two companies share in common a technology, customer base or other characteristic, but otherwise operate in different markets.

4. Conglomerate: The companies have little or no connection.

Horizontal mergers will usually generate the most economies of scale and offer the greatest opportunities for both cost savings and revenue generation. Conglomerate transactions, on the other hand, typically offer the lowest synergies. Most buyers are willing to pay a higher premium for similar companies than dissimilar ones.

Valuing Synergies

Valuing synergies depends on the buyer’s unique investment objectives. Every synergistic buyer will have different anticipated benefits from the acquisition. Therefore, the value of synergies is unique to each buyer. A buyer can measure the premium it can afford by assigning reasonable values to any costs savings and revenue increases expected from the transaction.

For example: Assume the only synergy expected from a merger is a $150,000 annual cost savings. The buyer needs to estimate what this $150,000 a year would be worth. Since the cost savings is expected to continue indefinitely, it can be valued taking the annual cost savings and dividing it by the merged company’s expected cost of capital. Assuming the expected future cost of capital is 15 percent, a buyer may be willing to pay up to a $1 million premium over fair market value ($150,000 divided by 15%). If the seller asked for more, the deal would not make economic sense to the buyer.

Failed mergers and acquisitions can usually be traced to one key reason: Buyers have unrealistic expectations of the possible synergies between the two businesses and overpay for the target company. Therefore, accurately estimating the value of the potential synergy is critical to the overall success of a transaction.

O’Keeffe & O’Malley can provide assistance in valuing synergies between two companies. Please contact us at 913.648.0185.