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When buying or selling a small or medium-sized business as part of an M&A transaction, it is particularly important to understand the difference between value and price. Investment legend Warren Buffett coined the phrase, “Price is what you pay; value is what you get,” highlighting the discrepancy between value and price in a transaction. However, this principle applies not only to the capital markets but also to M&A transactions involving small and medium-sized enterprises. The purchase price in a transaction is always determined by the interplay of supply and demand.
The Importance of Business Valuation in M&A Transactions
M&A transactions are complex processes involving the purchase, sale, or merger of companies. A well-founded business valuation is an essential component of the transaction, as it serves, in particular, as the basis for negotiations for both parties. Regardless of the attractiveness of the target company, the business valuation prepared by the buyer or seller can serve as the reserve price—the starting point for each party’s negotiations—to ensure the company is not sold below its value (seller) or at a significantly inflated price (buyer).
Specific Challenges in SME Transactions
Both M&A processes and business valuations of SMEs are subject to specific challenges. Valuing SMEs is significantly more complex than valuing large companies, as SMEs are typically much more closely tied to the business owner and significantly influenced by them. The business models of SMEs are usually highly specialized and not diversified across industries to cushion potential market fluctuations.
Another distinctive feature of transactions in the SME sector is the lower level of transparency due to reduced reporting requirements. In addition, SMEs often have no business plans—or only rudimentary ones—regarding expected business development, which are, however, of essential importance to buyers and for business valuation.
Business Valuation Methods
Various methods have emerged for business valuation in the context of M&A transactions, which enable the determination of a company’s value. The choice of method depends on various factors, including the type of company, the industry, and the available data. In general, a multi-method valuation is recommended to verify the individual approaches and to assess the overall picture of the company.
Net Asset Value Approach: This approach values the company based on its tangible assets, i.e., capitalized assets such as machinery, real estate, or inventory (fair values!), and after deducting liabilities to be serviced. This method is particularly suitable for capital-intensive companies (manufacturing) and, in accordance with the requirements of the IDW S1 valuation standard and the German Valuation Act (BewG), represents the lower limit of the company’s value.
Income Approach: This method is the standard approach in accordance with the requirements of IDW S1 and takes into account the company’s future earnings. These earnings are the key metric for investors. In addition, the method offers the possibility—for example, within the framework of scenario analyses—to explicitly incorporate the respective future expectations of the buyer and seller into the business valuation.
Market Value Approach Here, the company’s value is determined by comparing it with similar, recently traded companies or industry multiples (e.g., DUB industry multiples). The availability and quality of the multipliers used are critical to the market value approach. Since industry multipliers are often published as ranges, the market value approach provides indicative value ranges that are used in particular to validate the income approach.
The Influence of External Factors
In addition to company-specific factors, external factors must also be taken into account when valuing SMEs in the context of M&A transactions. These include, among other things, macroeconomic conditions and industry-specific trends, as well as the availability of liquidity among investors and the attractiveness of investments in the capital market.
Conclusion
Valuing companies in small and medium-sized M&A transactions requires a thorough analysis and a deep understanding of the company being valued. Unlike with large, publicly traded companies, personal and individual factors often take center stage in the case of SMEs, and the transaction encompasses the entire company rather than just individual shares. A careful valuation is therefore essential to provide both buyers and sellers with a solid foundation for their negotiations.
