Three Ways CFOs and CDOs Can Get Digital M&A Valuation Right

By EY

Acquiring a digital asset can lead to growth, revenue synergies and other value that can be quantified when there is a clear business case.

In brief:

New technology is disrupting markets and can require a fresh set of metrics to calculate the value that digital assets bring to a buyer’s business.
Calculating digital M&A risk accurately may be crucial to avoiding overpayment and losses down the road.

A consumer company announced the sale of an asset that was no longer core to its business. On the surface, the sale made sense, as it was a digital asset that didn’t fit the company’s long-term strategy. But the sale price of the asset was a significant discount to the purchase price a few years earlier, despite the platform’s success and a significant increase in applicability in a pandemic world. So, what happened?

This case study is an example of an industry mash-up where an organization purchased a digital asset without a clear idea of how it fit into the organization’s ecosystem or the value creation possible through successful integration. Unfortunately, as valuation professionals, we have worked with executives including CFOs and CDOs on many digital acquisitions where it can be clear to us during the purchase process that companies are likely to revisit the asset in the future as part of impairment or other financial reporting write-down exercises.

As more companies consider digital assets as part of their inorganic growth strategies, it may be helpful to focus on those steps that will improve the chances of success. The best run processes likely have well-thought-out value statements that consider not only what the target organization brings to the table on its own, but also the synergies that will be created by combining it into an existing ecosystem. When there is a strong understanding of value, diligence can focus on areas that inform forecast models and support the business case presented to the board. Integration activities then follow to allow value capture and potential success in the long term.

Understanding how to quantify value in this context can be critical and here we present three considerations based upon our experiences in digital M&A valuation.

1. Uncover the true acquisition business case

The first and most important step in valuation is developing a clear purpose for the acquisition. Clarity — about what you hope to achieve from it and how it links to your overall strategy and capital allocation policy — can be critical. In some cases, brand or product transformation may be more important than cash flow in the near term. Correctly understanding and assessing the synergies that are derived from enhancements to the target and the core business may be critical and can be difficult to measure directly.

For example, enhanced brand or employee satisfaction that increases long term value. Ultimately, these enhancements can lead to financial impact but it may be years down the road. Commercial diligence is often relatively more important in a digital transaction, and knowledge of customer sentiment may be critical to building an appropriate business case. Understanding the relevant market forces, likely in a market the buyer is less familiar with, can focus diligence efforts to better inform valuation.

2. Identify valuation metrics in new markets

Once the purpose is clear, the same valuation methods apply to digital acquisitions, but different value drivers can be considered, especially when entering new and different markets. Identifying key performance indicators (KPIs) can be key and may include subscriptions, annual recurring revenue (ARR), customer lifetime value, churn and more. Next, the data can be sensitized using a robust driver-based deal model.

Synergies are another value driver that often needs to be considered differently. In digital acquisitions, cost synergies may not be present and being realistic about the ability to scale margins is an area where buyers can be too optimistic. Revenue synergies may be unrelated to the buyer’s business, but the use of third parties to vet key assumptions can help challenge traditional thinking. When it comes to integration and cost assumptions, recognizing different cultures and organizational structures is important, as heavy integration and the desire for conformity can stifle innovation.

3. Study how synergies may impact risk

When it comes to valuation, the bottom line is appropriately measuring risk. All too frequently for non-digital buyers, recognizing the differences from the buyer’s current business is a blind spot. The current cost of capital is likely irrelevant, the buyer may not have the in-house capability to assess technology risk, there may be key talent risks that are unfamiliar, and the list goes on. Far too often, we have worked with buyers that apply their internal hurdle rate to the cash flows of a much riskier business. This can lead to overpayment and value loss down the road.

In the case of the consumer company above, the target performed well, and value could have been created, but due to different perspectives on risk the buyer started with a price that was too high. So, how do you make more informed valuation decisions? If aspirations are linked to long-term strategy and the right KPIs have been identified, challenged and sensitized, a clear picture of risk can become apparent. Buyers can then make informed decisions about risk adjusting the cash flow forecasts, the discount rate or the deal multiple. Sometimes a buyer may have to walk away from a deal if the economics don’t make sense. Other times, a higher multiple can be justified. Neither decision can be made confidently if all the aspects of valuation haven’t been appropriately vetted. Valuation techniques are what they are, but it’s the assumptions that go into the model and the risk associated with those assumptions that can drive successful outcomes.

The article was first published here.

Photo by Sajad Nori on Unsplash.