Valuation Of Companies For Mergers And Acquisitions Transactions

Author – By Upscale Legal 

 

INTRODUCTION

Indian Economy has been transformed and opened the floodgates of opportunities for trade and commerce through Liberalization, privatization, and globalization reforms. Consequently, transactions involving Mergers and Acquisitions (hereinafter referred to as M&A) have increased exponentially. In layman’s language, mergers can be defined as the unification of two entities into a single entity and acquisitions mean when one entity buys the other to combine the bought entity with itself.^[1] Now, let’s assume that you want to purchase a property, what would be the key point you would think about before initiating the process of purchase? It would likely be the valuation of that property. Similarly in an M&A transaction also, the valuation of the target company is a quintessential factor to initiate the process of M&A.

Valuation in simple words means the consideration that one party would pay to the other, it can also be in a form of the firm’s stock in the case of a public company.^[2] In this article, we will be discussing some key factors related to the valuation of companies in India for M&A transactions.

Importance of correct valuation

The inaccurate valuation of an entity affects negatively the entities involved in M&A transactions. Ideally, the sum of the independent values of the entities should equate to the combined values of the entities involved in the M&A transactions. Even though there are specific approaches and methodologies for valuation, it is a very complex process and careful consideration is required.

Since there is a high risk involved, it has a potentially negative effect on the entities involved in M&A transactions. It is of paramount importance to determine the right value of entities using the correct methods and approaches. This will require a complete understanding of various attributes for correct entity value and some external factors as well, for example, market trends, competitive forces, etc. To increase the advantages of M&A transactions and minimize financial losses, companies should adopt a meticulous method for valuation.  As it is known that the primary purpose of doing business is to earn profits, similarly the need for valuation in such transactions is to ensure maximizing the benefits.

Techniques used for valuation:

During the course of time, there are many techniques used for analyzing the actual valuation of a company based on different approaches. Four commonly used techniques are as follows:-

1. Market Value: This technique is exclusive to quoted corporates. In this technique, the quoted share price of a company is multiplied by the number of shares issued. By doing this, the market value is determined. This helps to analyze the price of the shares of the company which the market at that particular time is willing to pay. This process is useful for an investor to keep in mind the performance of the company and the capabilities of the management to benefit from their investment.^[3]
2.  Discounted Cash Flow Analysis: It is a type of technique that helps in determining if an investment is worthwhile for the future. It is based on the ideology to keep a tab on the future, as to how well an entity can generate cash flows for its investors.^[4] In this technique, it is assumed that the valuation of a company can be done by calculating the current value of its projected future earnings and its terminal value. To apply this method, the valuator must verify that the company’s projected earnings are based on realistic assumptions made by its management and are likely to represent reasonable future earnings.
3.   Comparable Public Company Method: For the valuation of a company, public markets are very efficient. Stock prices are determined by the decisions of buyers and sellers all around the world. In this process, to value a private company, already existing similar public companies are used as a touchstone. The methodology of this process is to first select a group of publicly traded companies that can be considered as representatives of the company which is to be valued. This will help the investors to see the target company and the compared companies as the same. The financial or operating data of each comparable company, for example, EBITDA, or book value, is compared to their total market capitalization to obtain a valuation multiple. The target company’s valuation is analyzed by calculating the average of these multiples.^[5]
4.  Comparable Transaction Analysis: This technique is quite the same as the comparable company analysis. The valuer in this method, to analyze the acquisition value of the target company, will take the help of recent acquisitions and takeovers. In this method, it is not necessary to value the takeover premium separately. It is a quite logical, simple, and straightforward approach. The analysis of recent acquisitions and takeovers gives fresh and recent values as they were recently finalized in the market. Unlike DCF analysis, this technique is not built on assumptions of various kinds. Since the valuation is established by the analysis of recent acquisitions, there is a very low possibility of legal disputes.

In India, the valuation process of a company is to be done by a Registered Valuer (RV). It is to make sure of transparency and unbiased process for both the acquirer and the target entity. RV is a professional who determines the valuation of shares, both tangible and intangible assets, etc. of a company.  In India, there is a requirement of training, 3 to 5 years of experience in the branch of valuation and a certificate of practice to be working as a Registered Valuer.

The Insolvency and Bankruptcy Board of India is a body that monitors the qualifications for a registered valuer. As per the guidelines, it is necessary for an RV to provide a valid certificate of practice and registration number when asked.^[6]

In the case of international transactions of M&A, the valuation is regulated by the Foreign Exchange Management Act, 1999 which prescribes that the valuation of these transactions shall be certified by a registered merchant banker[7] with SEBI.

Due Diligence

In every M&A, there will be a buyer/acquirer and the seller/target entity. There is a practice of due diligence in these transactions, where the buyer/acquirer will be getting access to all the information related to the business being acquired, for example, intellectual properties, outstanding legal matters, any equipment and finances, all the existing contractual obligations, etc.

During due diligence, the buyer would want to hire the experts like advocates and financial advisors to conduct a full-fledged analysis of the target entity. It is a sort of investigation of a target entity before finalizing the agreement.[8]

To look at a company’s financial and legal records which helps in analyzing its overall health and potential risks, lawyers and financial advisors conduct a due diligence review. It is a crucial process to determine the company’s valuation since it gives important information about the entity’s legal compliance and financial performance.

Financial advisors play an important role in valuation determination as they examine the company’s financial statements, financial records, etc. They may also take a look at market trends to evaluate the financial position of a target entity in relation to its peers.

Conclusion

Mergers and Acquisitions (M&A) have become a necessity to survive in this competitive environment, it is very common that to either survive or to expand, companies are willing to undergo M&A transactions and the valuation of the companies involved is a crucial process. Significantly, accuracy should be achieved when the valuation is under process. Since it is a major factor that impacts the success of the transaction and potential financial losses. Hence, it is important that RV uses an appropriate method for the valuation of the companies involved as correct valuation will ensure the maximum benefits while minimizing the risks of financial loss.

 

[1] https://www.mca.gov.in/MinistryV2/mergers+and+acquisitions.html

[2] https://www.icsi.edu/media/webmodules/FINAL_VALUATION_BOOK_25022020.pdf

[3] https://www.mondaq.com/india/maprivate-equity/266274/corporate-valuation

[4] https://www.theforage.com/blog/skills/dcf-valuation

[5] ibid

[6] https://www.mondaq.com/india/shareholders/1023392/registered-valuer-requirements-a-brief-summary-of-the-companies-act-requirements-and-their-overlap-with-other-laws#:~:text=Registered%20Valuers%20may%20be%20Chartered,assets)%20or%20specialised%20valuation%20professionals.

[7] SEBI (Merchant Bankers) Regulations 1992.

[8] https://auren.com/il/services/corporate/valuations-mergers-acquisitions-and-due-diligence/