Factors Impacting the Determination of Purchase Price

Contact Neufeld Legal PC for corporate transactional and legal matters at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

The determination of the purchase price for a business acquisition is a complex process influenced by a variety of factors, with the application of those factors both in the computation and negotiation process being essential to realizing an acceptable purchase price to advance the business transaction. There are numerous concrete factors that typically go into the determination of the purchase price; nevertheless, there are numerous factors that are highly dependent on individual circumstances, such as the reasons and motivations for selling the business, which can have an enormous impact upon the determination of the purchase price if appropriately negotiated.

A. Financial Performance & Valuation

The target company's past and projected financial performance are the most critical factors in determining its value.

• Revenue and Profitability: Strong, stable, and growing revenue streams, along with healthy profit margins, significantly increase a company's value. Buyers often analyze key metrics like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which measures a company's operational profitability. A common valuation method involves applying an industry-specific multiple to the target's EBITDA.

• Future Growth Potential: The potential for future growth is a major driver of a premium price. This includes the ability to expand into new markets, develop new products or services, and the scalability of the business model. A company with high growth potential, even if currently unprofitable, may command a higher price.

• Recurring Revenue: Businesses with a high percentage of predictable, recurring revenue (like subscriptions or long-term contracts) are generally valued more highly due to the stability and predictability of their cash flow.

• Valuation Methods: Buyers use various valuation methodologies to arrive at a fair price [more on valuations].

  • Income Approach: This method, often using Discounted Cash Flow (DCF) analysis, values a business based on the present value of its future cash flows.

  • Market Approach: This approach compares the target company to similar businesses that have been recently sold (precedent transactions) or to publicly traded companies in the same industry.

  • Asset-Based Approach: This method, more common for asset-heavy companies, values the business based on the fair market value of its tangible and intangible assets, minus its liabilities.

B. Due Diligence & Risk Assessment

Due diligence is the comprehensive investigation of the target company. The findings can lead to significant adjustments to the initial offer price.

• Liabilities and Debt: Any outstanding debt, potential legal liabilities, or other financial obligations discovered during due diligence will reduce the purchase price. Quality of Financials: The cleanliness and reliability of the target's financial records are crucial.

• Audited financial statements provide a greater level of assurance and can lead to a higher valuation.

• Working Capital Adjustments: The purchase price is often adjusted based on a comparison between the target company's actual working capital at closing and a pre-agreed-upon "target" level. This mechanism ensures the buyer inherits a normal and sufficient level of capital to operate the business post-acquisition [more on financial due diligence].

• Operational and Legal Risks: Buyers look for operational risks like high employee turnover, reliance on a single key customer or supplier, or compliance issues [more on operational due diligence]. Any legal disputes or intellectual property concerns can also decrease the value [more on legal due diligence].

C. Strategic Factors

The strategic fit between the buyer and the target company can justify a premium price above and beyond the financial valuation.

• Synergy: This is the idea that the combined value of two companies is greater than the sum of their individual parts. Buyers are often willing to pay a premium to capture these synergies.

  • Cost Synergies: These involve reducing redundant expenses by combining operations, such as consolidating back-office functions, closing overlapping facilities, or gaining greater purchasing power.

  • Revenue Synergies: These focus on increasing revenue by leveraging the combined entity's capabilities, such as cross-selling products to each other's customers or expanding into new markets.

• Intangible Assets: The value of a business is not solely based on its tangible assets. Brand reputation, intellectual property (patents, trademarks), customer relationships, and a talented management team are all intangible assets that can significantly increase the purchase price.

• Market Conditions and Competition: The state of the merger and acquisition market, the industry's economic outlook, and the level of competition for the target company can all influence the final price. A bidding war, for example, will almost certainly drive the price up [more on commercial due diligence].

D. Special Circumstances

Special circumstances can arise that will dictate that the traditional approach to a business purchase and sale is replaced by what can be a significantly altered transactional arrangement to facilitate the disposition of the business.

• Death of the Business Owner: The untimely death of the business owner can necessitate the sale of the busines by the executor / administrator of their estate, which can also arise when the designated successors are unwilling to assume control and responsibility for the business [more on Business Transactions on Death].

• Terminal Illness or Permanent Disability of the Business Owner: When a business owner's health worsens, in particular when they are diagnosed with a terminal illness or they become permanently disabled, divesting control and ownership of the business becomes an increasingly pressing matter [more on Business Transactions on Illness].

• Departure of the Business Owner: Circumstances, often unrelated to the business, can effectively force out a business owner and necessitate the sale of the underlying business, including personal burn-out, stress, loss or serious illness of a family member, divorce, criminal activity, personal financial issues [more on Business Transactions on Departure].

• Financial Business Collapse: Even when a business takes a significant financial hit, the entire business (or component parts of the business) may still have value that can be sold off, as it could not survive with its current ownership [more on Business Transactions on Financial Collapse].

When it comes to the legal component of corporate mergers & acquisitions, that is when the law firm of Neufeld Legal P.C. comes into play. Such that when your company is seeking knowledgeable and experienced legal representation in orchestrating and completing business mergers, acquisitions and divestitures, contact us at 403-400-4092 [Alberta], 905-616-8864 [Ontario] or Chris@NeufeldLegal.com.

Investigating Business Owner's Reasons for Selling: All too often, prospective business purchasers have not looked into the underlying reasons behind the existing business owner's interest in selling their corporate enterprise, even though such information could have proven highly beneficial to their negotiations related to the business acquisition and the purchase price. Read more.

 

Factors Impacting the Determination of Purchase Price: The determination of the purchase price for a business acquisition is a complex process influenced by a variety of factors, with the application of those factors both in the computation and negotiation process being essential to realizing an acceptable purchase price to advance the business transaction. Read more.