Financing a Business Acquisition: Methods and Strategy

Introduction

After twelve years in business, our company has enjoyed a strong run of success — expanding operations, achieving consistent profitability, and moving into franchising. In order to pursue a nationwide strategy with an eye toward eventually going global, we are evaluating several expansion options. One of the most promising is acquiring a direct competitor. This paper analyzes that acquisition, with particular focus on how to value the target company and how to finance the transaction.

Business Valuation Methods

Several business valuation methods can be applied to analyze a prospective acquisition target. These include adjusted book value, capitalized adjusted earnings, discounted future earnings, the cash flow method, and the gross revenue multiplier (Collin.edu, 2013). A sixth approach is to base the valuation on the stock market valuation of a comparable public company. Because the target is a private company and no suitable public comparable exists given its size, this option is rejected. The remaining five methods all rely on analyzing the target's financial statements — which the seller would be expected to provide.

The adjusted book value method reflects the idea that we are primarily paying for the firm's assets. This makes sense in our case, because we bring our own brand and management systems to the table. The assets being acquired — including the established customer base — are the core value. By taking the book value and adjusting for off-balance-sheet assets and liabilities, then paying a modest premium, we arrive at an adjusted book value.

The capitalized annual earnings method bases the price on accounting profits. One drawback is that we are paying in cash, so cash flows are arguably more relevant than accounting profits. A more significant concern is that many acquisition targets are on the market precisely because they are losing money. Given the industry's vulnerability to management problems and local economic conditions, assuming limited profitability means this method may not be appropriate.

Discounted future earnings address this weakness by focusing on earnings projected under our management rather than results under the prior owner. Accounting profit remains the starting point — not least because equity markets also rely on it — but the forward-looking orientation makes this approach more realistic. By using expected future earnings under our management, we capture the value of the acquisition to us specifically.

The cash flow method discounts cash flows rather than accounting earnings. In its simplest form, the prior year's cash flows are assumed to continue in perpetuity — an unrealistic assumption, but one that can be adjusted. The better approach is to model an expected base level of cash flow and incorporate a growth rate. This method is especially appropriate for valuing a private acquisition because it lets the acquirer estimate value from its own perspective and run a sensitivity analysis to set a maximum acceptable purchase price.

The gross revenue multiplier applies a standard multiplier to current gross revenue. This method is significantly weaker than the cash flow approach because it ignores expense-side cash flows, which can materially affect firm value. This limitation is particularly problematic here, since the target's cost structure is likely to closely resemble our own — making expense-side dynamics highly relevant.

Discounted Cash Flow Analysis

The discounted cash flow (DCF) model is the most appropriate valuation tool for this acquisition. Future cash flows are discounted at the company's cost of capital, estimated here at 11%, and compared against the $100 million purchase price.

The analysis yields a net present value of approximately $12.6 million, implying the acquisition is worth roughly $112.6 million to our company. At an asking price of $100 million, this transaction adds value and should be pursued once financing is secured.