Canada: Acquisitions and Strategic Value

Last Updated: September 28 2015
Practice Guide by Duff & Phelps

A strategic buyer is defined as one that believes it can generate incremental value following an acquisition by combining the acquired firm with its existing operations. In an open market transaction, expected post-acquisition quantifiable synergies combined with perceived strategic value often are important factors affecting the negotiations between buyer and seller. This article sets out the various types of synergies that strategic buyers frequently anticipate will be realized, and how those synergies generally are quantified.

Components of value and price

There can be, and often is, a significant difference between the ‘value’ (normally defined as fair market value or some other value term) of the shares or net assets of a particular business and the price that is paid for those shares or net assets.

In a notional market context, the ‘value’ of the shares or net assets of a going concern business on a stand-alone basis frequently is determined based on the intrinsic discretionary (after tax) cash flows the target business prospectively will generate, and the risks attaching thereto. In this context, value generally is referred to as ‘intrinsic value’ (or ‘stand-alone’ value), and normally is comprised of:

  • the value in use of the underlying pool of net tangible assets of the business (which in itself typically incorporates subjective elements); and
  • in many cases, commercial goodwill, being the amount by which the estimated stand-alone value of the shares of the business determined pursuant to a cash flow based valuation methodology exceeds the value in use of the underlying net tangible assets. Commercial goodwill may include both identifiable intangible assets (‘brands’, for example) and intangible value which can not be specifically attributed and which hence is simply referred to by the catch-all term ‘goodwill’.

In theory, intrinsic value should not be less than the net after-tax proceeds that would be obtained on the liquidation of the net assets of the business.

Conversely, the price paid for the shares or net assets of a business in an open market transaction generally is influenced by (among other things) the buyer’s and seller’s perception of the post-acquisition synergies that will arise following an acquisition. In most cases, buyers are in a better position to identify and quantify expected post-acquisition synergies, and a vendor can only speculate as to what those benefits may be and the level of importance to a particular buyer. Synergies may affect price to the extent that the purchaser believes that the potential benefits are realizable and will negotiate to pay for some or all of them. Accordingly, price as negotiated between the buyer and seller in an open market transaction may be equal to or greater than (and in some cases, possibly less than) intrinsic value, and typically will vary (often significantly) among possible buyers. The components of value and price can be summarized as follows:

Types of synergies

Post-acquisition synergies are defined as those that increase the value of the combined business beyond the sum of its components (i.e. the intrinsic value of the acquirer and target company) by way of:

  • increasing the quantum of prospective discretionary cash flows;
  • reducing the risk of achieving prospective discretionary cash flows; and
  • creating growth opportunities and strategic advantage not specifically quantified.

These benefits may accrue to the acquirer (including its existing affiliates), the acquired business or a combination thereof.

In most transactions, each potential buyer has a unique expectation as to the type and value of synergies that will arise from a particular acquisition. Empirical data accumulated in 1998 by Toronto-based Campbell Valuation Partners Limited found that over 80% of corporate acquirers typically consider post-acquisition synergies in assessing the value of an acquisition target. Of those 80%-plus acquirers who consider synergies, more than one-half indicated that they normally incorporate 50% or less of the value of anticipated synergies in their acquisition pricing analysis.

Examples of the types of synergies commonly anticipated are set out below. Although these benefits have been categorized as marketing, operating, financial and strategic, these classifications sometimes overlap.

Marketing

  • benefits associated with increased market share, such as savings in advertising costs or increased corporate awareness;
  • the elimination of a competitor, thereby reducing price competition and the threat of new products being introduced by that competitor;
  • improved market coverage resulting from the integration of product lines;
  • access to new customers to whom the acquirers’ existing products can be sold; and
  • improved distribution of products from better utilization of the marketing organization and distribution channels of the combined entities.

Operating

  • the ability to immediately transfer technology of the purchaser’s business to the vendor’s business (or vice versa), thereby increasing profitability and eliminating the time that the vendor would otherwise require to develop the same capabilities internally;
  • higher capacity utilization leading to incremental throughput, utilization of engineering and design services, and overall operating efficiencies;
  • increased purchasing power; and
  • headcount reductions.

Financial

  • accelerated growth potential for the vendor’s business through access to lower cost and/or more varied financial resources enjoyed by the purchaser;
  • benefits associated with a more efficient capital structure for the combined firm arising from its greater consolidated asset base and improved cash flow generation capability following the transaction; and
  • where the acquirer is a publicly held company, greater size may lead to increased investor interest and stock analyst coverage, thereby reducing the acquirers’ cost of raising equity capital.

Strategic

  • acquisition of additional capacity and / or existing know-how and market presence on a ‘buy’ rather than ‘build’ basis;
  • potential risk reduction resulting from upstream / downstream integration opportunities;
  • entry into a new strategically important market, from either a product or geographic standpoint;
  • a reduction in risk through greater diversification of products and / or markets; and
  • so-called ‘scarcity value’ related to the unusual or unique attributes of the target company as viewed by acquirers.

Costs of realizing synergies

While corporate acquirers frequently emphasize the anticipated benefits from an acquisition, they often do not give adequate pre-acquisition consideration to the costs of integration, the timing of the anticipated proceeds, and the probability factors related to the actual realization of the perceived benefits. This may occur because synergy assessments:

  • are overly optimistic as a result of inadequate analysis;
  • are overly optimistic in order to rationalize the price that is perceived necessary to secure the acquisition; or
  • do not adequately consider post-acquisition competitor strategies and activities.

Examples of incremental expenditures that may be required to realize anticipated synergies include:

  • severance costs associated with headcount reductions;
  • lease termination payments and facilities disposition costs, including relocation expenses;
  • general integration and monitoring costs related to the implementation of policies and procedures, quality standards, computer system integration, and so on;
  • turnover of key personnel in the acquired business due to uncertainty, differing management philosophies, or who seek other career opportunities;
  • deferred costs, where the vendor has deferred certain expenses (such as equipment maintenance, research and development, advertising, and so on) in the months (or years) prior to sale in order to improve its financial results;
  • contingent or inadequately accrued liabilities, including pending litigation, post-retirement benefits, warranty reserves, environmental and cleanup costs, and so on; and
  • capital expenditures and working capital requirements needed to finance anticipated revenue growth.

Quantifying synergies

The quantification of post-acquisition synergies should be a separate and distinct component of any business valuation exercise. Therefore, the intrinsic value of the business should be estimated as the ‘base value’ and the value of synergies added to that base. This segregation not only assists in evaluating the reasonableness of the components, but in an open market transaction, the acquirer’s pricing and negotiating strategy should consider the portion of expected synergies it wants to ‘pay for’. Where a purchaser does not pay for it, expected synergies serve to compensate for unanticipated shortfalls from expected post-acquisition discretionary cash flows. No acquisition review can be so complete as to eliminate all post-acquisition surprises. In many instances, a lower level of post-acquisition benefits and a higher level of costs materialize following acquisition than were anticipated during negotiations. Consequently, if the value-added component is fully paid for, the purchaser has eliminated all downside protection and the likelihood of acquisition success is reduced.

A proper quantification of post-acquisition synergies requires a balanced, realistic perspective of the perceived benefits that will arise following an acquisition, as well as an assessment of the likely timing and incremental costs to be incurred in their realization. For the purpose of analysis, post-acquisition synergies generally can be segregated into tangible operating synergies, intangible operating synergies and financial synergies, as indicated in the chart below.

Tangible operating synergies are those benefits that can be readily isolated and quantified in terms of incremental prospective discretionary cash flows, such as specific revenue opportunities and cost reductions. The quantification of tangible operating synergies generally involves determining the incremental discretionary cash flows expected to accrue to the purchaser, net of the costs of realizing expected synergies, and related income taxes. The net incremental discretionary cash flows should be projected on an annual basis and discounted at a rate of return that appropriately reflects the risk in achieving the benefits. Alternatively, expected synergies can be expressed net of a ‘probability factor’ to reflect the risk of their realization, which is the approach more frequently used in practice. In this case, the probabilized synergies typically are discounted at more moderate ‘market driven’ rates of return, commonly the rate of return used in estimating the value of the target business on an intrinsic basis. A discounted cash flow methodology generally is the preferred approach to quantifying tangible operating synergies since it explicitly considers the expected timing of the anticipated benefits and all of the related costs, including incremental capital expenditure and working capital requirements.

Intangible operating synergies are those benefits that cannot readily be segregated and analyzed on an individual basis. Intangible operating synergies typically relate to incremental growth opportunities, a reduction in business risk of the combined firm, or other strategic advantages that have not been included as part of post-acquisition incremental discretionary cash flow. Although the value of intangible operating synergies generally is very subjective, in theory these benefits may be quantified by applying a lower rate of return to the discretionary cash flows of the target business than would otherwise be applied in valuing the target business on an intrinsic basis. In practice, corporate acquirers frequently adjust their price upward in recognition of strategic importance and other intangible operating synergies expected to arise from an acquisition. However, the quantification of such benefits often is more influenced by an acquirer's qualitative assessment of the level of importance and amount of competition for an acquisition candidate than it is by a purely mathematical exercise.

Financial synergies are those benefits associated with a more efficient capital structure and / or lower cost financing available either to the vendor, the acquirer, or the combined firm as a result of the acquisition. Financial synergies can be quantified as the increase in the intrinsic value of the target business (or acquirer or combined firm, where applicable) based on a lower rate of return due to a more efficient capital structure or lower cost financing arising from the acquisition. In practice, corporate acquirers sometimes assess financial synergies on a qualitative basis.

Synergy valuation example

Buyerco is considering the acquisition of Targetco and has estimated the intrinsic value of the shares of Targetco to be $23 million, based on Targetco’s annual prospective discretionary cash flows of $2.5 million and an 11% rate of return (i.e. capitalization rate), which Buyerco considers appropriate in this case. In addition, Buyerco anticipates that the following post-acquisition synergies will arise through the purchase of Targetco:

  • staff reductions resulting in savings of $400,000 per annum. Severance costs are expected to be $200,000. Buyerco’s income tax rate is 40%;
  • incremental revenues of $1 million in the first year following acquisition, $2 million in the second year and $3 million in the third year and thereafter. Targetco’s contribution margin on incremental sales is estimated at 30%. Due to excess operating capacity at Targetco, it will not incur any incremental fixed costs or additional capital expenditures. Working capital requirements are estimated at 10% of revenues;
  • due to Buyerco’s ability to utilize a more efficient capital structure in its consolidated operations, the required rate of return for Targetco will decline from 11% to 10%; and
  • Buyerco views the acquisition of Targetco as strategically important because it will allow Buyerco access to an important new market that would have been difficult to enter absent this acquisition. Buyerco estimates the value of this benefit to be $5 million.

Assuming that Buyerco applies a 50% probability factor to anticipated post-acquisition synergies and that a 10% rate of return is considered appropriate, the price Buyerco may be prepared to offer for the shares of Targetco is estimated as follows:

Concluding comments

The quantification of perceived post-acquisition synergies is a subjective and fact-specific exercise. However, in any open market transaction it is important for both the buyer and seller to consider what anticipated synergies might arise and to attempt to quantify their value. From the seller’s standpoint, this will assist in determining which potential purchasers to solicit and the estimated price that each might pay. For the purchaser, an assessment of synergies is important from the perspective of determining all the potential value components of the acquisition candidate, and in estimating the price that competitors might pay. In most cases, both the prospective buyer and seller in an open market transaction improve their respective negotiating position through a detailed and objective assessment of anticipated post-acquisition synergies, the expected timing of those benefits, the related costs, and the likelihood of their ultimate realization.

This document is not intended to create an attorney-client relationship. You should not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult a professional legal services provider.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Contact the Author?
Click here to email the Author
In Association with
In Partnership with
Other Canada Advice Centres
Competition and Antitrust
Mergers and Acquisitions
Labour and Employment
More Advice Centers
Useful Resources
CBVs are experts in their field. The following articles and papers have been written by CBVs, several articles have been featured in various national publications.
Tools
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.