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Digital M&A valuation: How CFOs and CDOs can get it right

Digital M&A valuation can require attention to unique key performance indicators (KPIs) and integration synergies.

In brief

  • In digital transactions, commercial M&A due diligence is critical in assessing technology risks.
  • Investors in digital assets likely will need to challenge traditional thinking and tie KPIs to deal valuation to reduce overpayment risk.

How EY can help

Many acquirers who pay a digital M&A valuation premium to buy transformative businesses, driven by technology, fail to put in motion the planning and integration steps needed to create value. Take a consumer company that 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 the use case for its product.

 

So, what happened? It is an example of an industry mash-up where a business purchased a digital asset without a clear idea of how it fit into the organization’s ecosystem or the value creation possible through successful M&A integration. Unfortunately, as valuation professionals, we have worked with executives, including chief financial officers (CFOs) and chief digital officers (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 with 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 on 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 can increase long term value. Ultimately, these enhancements can have a 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 digital M&A valuation metrics in new markets

Once the purpose is clear, standard valuation methods apply to digital acquisitions, but different value drivers can be considered, especially when entering new and different markets. Identifying KPIs can be key and may include subscriptions, annual recurring revenue 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 buyer may not have the in-house capability to assess technology risk or there may be key talent risks that are unfamiliar among other potential issues. 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.

Summary

M&A valuation methods are what they are. But the marriage of two businesses has more complexities when one company brings a new layer of digital prowess. It’s vetting the assumptions that go into the digital M&A valuation model and the risk associated with those assumptions that can drive successful outcomes in mergers and acquisitions involving digital assets. Buyers focused on measuring risk in the M&A diligence phase can avoid valuation missteps that lead to overpayment.

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