Standalone value is a valuation method that determines the value of a company in its current value before a merger and acquisition deal. It is used to determine the suitability of a target company as a merger or acquisition partner, and the synergistic effect that the transaction will bring to the acquirer.
Some of the items included when determining the present value of the company include personnel, asset base, distribution channels, current production or service structure, and operating cost structure.
In some cases, the value of an acquisition target may exceed the estimated standalone value to the acquirer’s company. It means that the acquirer will derive more value from the transaction than the combination of the two companies’ assets.
For example, when acquiring a software company, the employees of the company create a synergistic effect in the acquirer’s company. If the company acquires the software company without its technical employees, the acquirer will not realize the synergistic effect immediately since it will be forced to incur additional costs to train new employees. In addition, the new employees will take time to get used to the internal systems of the acquired company.
What is the Synergy Effect in M&A Deals
Synergy is one of the metrics that parties in a mergers and acquisitions deal use to justify the transaction and the transaction price. Usually, the cost of acquisition is calculated by taking into account the expected benefits to both companies post-acquisition. The benefits that the two merged companies enjoy are referred to as synergies. Synergy may be classified as operating and financial synergies.
1. Operating synergies
Operating synergies refer to the ability of the transaction to increase returns generated by assets and accelerate the growth of the company, which results in increased cash flows for the combined entity. An example of an operating synergy is the economies of scale generated by the transaction.
Since the firms cease functioning as two different entities, they eliminate costs that were previously incurred individually such as distribution costs, administration costs, and rental costs. The merged company also benefits from a large number of product and service offerings, and a large pool of prospective customers.
2. Financial synergies
Financial synergies involve the improvement of financial performance that two firms enjoy when they merge into one larger company. The improvements include increased debt capacity, lower cost of capital, improved cash flows, and tax benefits. The combined company enjoys higher bargaining power and can be able to negotiate a lower cost of capital from financial institutions.
It can improve its borrowing capacity since it achieves more stable cash flows and earnings that give assurance to creditors that the company will be able to meet its debt obligation. The acquirer also creates tax benefits when it acquires a loss-making entity since it reduces the overall tax burden.
Although companies mostly focus on positive synergies, an acquirer may also experience negative synergies, where the combined firm experiences declined financial performance post-acquisition. For example, the merged company may be forced to incur additional costs to train its new employees and hire more experienced personnel to strengthen its management team.
Also, acquiring a target company with a negative financial reputation among lending institutions may affect the acquirer’s debt capacity, since most lenders will be hesitant to lend large amounts of debt in the combined entity to protect themselves from the risk of default.
How Standalone Value is Used
Standalone is used to determine the suitability of an acquisition target in the M&A deal, and if the transaction will improve the acquirer’s valuation post-acquisition. Therefore, the acquirer must conduct due diligence on the target company to determine the ability of the target to create positive synergy in the parent company.
The due diligence involves calculating costs that the acquirer will incur before the full incorporation of the target’s infrastructure into the company. The costs include asset depreciation costs, acquisition of new infrastructure, cost of training new staff, cost of re-organizing the executive team, etc.
A target company with unique assets or capabilities such as a patented system and proprietary technology is able to attract a premium price during acquisition because of a higher standalone value. The purchase price would be higher if the acquirer estimates that it will generate more revenues with the acquired company than the revenues that the target company could’ve generated in the future if it continued operating independently.
The additional value generated is referred to as synergy, which can be measured by the increased operational efficiencies and strong financial performance of the merged company.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:
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