It’s an axiom of business that “the whole is greater than the sum of the parts.” Through the magic of synergy, a company can often create value by combining two or more things (e.g., businesses, products, marketing ideas) that interact positively and result in more than a purely additive outcome.
The same result can often be seen in business valuation. For example, two companies, each with $10 million in revenue and $2 million in earnings, might become more valuable simply by combining into a single company with $20 million in revenue and $4 million in earnings. (While there are a number of factors that make this true, a discussion of them will have to wait for a future post about business valuation.)
However, I believe that the way people handle business negotiations often results in “negative synergy,” where the whole becomes less than the sum of the parts. The problem that arises is something akin to the volume discount. When I represent a client that is selling (or licensing) something, I believe it is critical to analyze the elements of value in silos. Then, the negotiation is about the fair price to be paid for each silo. If you only think of them as a bundle, the total price may look good on the surface, but could well result in leaving significant value on the table.
Consider a business owner trying to sell her business. If she focuses only on the value to be paid for the company as a whole, she might miss several elements of value that really should be discussed separately:
- Executive Compensation: If the owner has employed herself in the business at a salary of $100,000, does that salary really reflect fair market value for the owner’s services going forward? If the owner plans to remain with the new company for an extended period, the value of her compensation should be specifically negotiated (with recognition of the fact that she would not then be an equity owner, except to the extent of any future option or stock grants).
- Real Estate: If the business owns real estate that is not income-producing (and therefore not valued in a straight discounted cash flow or multiples analysis), that real estate may have appreciated significantly in value and the price to be paid for it in the sale can be negotiated separately.
- Divisions: If the business has two divisions, one of which is mature and profitable with slow growth, and the other young and unprofitable but growing quickly, it may be a mistake to value those two divisions together.
- Revenue Sources: Similarly, if the business (e.g., a software company) has three sources of revenue – software sales (high margin), hardware sales (low margin) and consulting, training or implementation services (medium margin) – it is important to consider the value of each source individually (recognizing, also, the fact that the three sources may be growing at different rates).
- Territories: Sometimes, territories should be analyzed separately, too. For example, if you have a product that is selling high volume in the U.S. but low volume in another market (such as the U.K.), in a simple analysis the sale price may be based on the U.S. business while the U.K. business is essentially thrown in for free. If the buyer is not willing to pay fair market value for the U.K. market (and, indeed, the rest of the world), it may make sense to retain rights to those other markets for which you are not receiving value. (Note that a similar problem arises in territory-based licensing arrangements, if you grant exclusive rights to a licensee for a geographic area that is significantly larger than the area that the licensee can effectively cover in the near term.)
The benefit of thinking about all of the elements of value in silos is that you will then know, with clarity, the “sum of the parts.” Moreover, you will be able to discuss each element of value with the potential buyer, which may have both marketing and price advantages.
Admittedly, careful analysis of each element of value does not guarantee that you will be paid the full value for each as determined by your analysis – but it does help to ensure that, if you must give a “volume discount,” both you and the buyer will have a reasonable sense of both the existence and size of the discount. In addition, if you have specifically identified extra value for the buyer that is not fully reflected in the purchase price, this extra value may be used as negotiating leverage in other areas of interest (e.g., indemnification baskets and caps).