Deals & Acquisitions
Feb 21, 2023
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This guide explains what precedent transaction analysis is and how this valuation method works. We will look at what precedent transaction analysis is, how it works, and the major mistakes to avoid with this valuation method. Here are some key takeaways about precedent transaction analysis:
Precedent transaction analysis is a method of business valuation that is commonly used to value privately held businesses. Here, we’re looking at past M&A deals and we’re using that data to value a similar business today. As an example, if Company A sold for 7 times EBITDA, then we can make a case that the business we are valuing today also justifies that multiple—provided that they are similar enough for the comparison to make sense.
The rationale behind this approach to business valuation is that the past M&A deal is proof that an acquiring business would pay that amount to acquire a similar business. The vast majority of M&A deals have competition among buyers, meaning that there are normally a number of prospective buyers willing to make offers to acquire another healthy company.
In order for precedent transaction analysis to work as a valuation method, we need to make sure the companies are actually similar enough to justify this inference of value. The business we’re comparing to should be of a similar size, operate with a similar business model, and operate in the same market.
As an example to better understand this, let’s look at SaaS (software as a service) companies providing customer support ticketing software. We’ll look at three businesses:
If you visit these websites you will see that these businesses operate in the same industry and have very similar business models. They are selling software for the same customer use case, for similar prices, in the same market.
As a hypothetical example, say that Zendesk sold for 10 times EBITDA. If an acquiring business were in negotiations with Help Scout, the Help Scout team would probably make a very good case that their business is worth 10 times EBITDA as well. After all, an acquiring business just paid that for a very similar company.
This is the rationale behind precedent transaction analysis as a valuation method. To understand this better, understand that in mergers and acquisitions, the acquiring business would have already performed a valuation of the target business before the negotiations begin. The goal in this prospective buyer’s valuation is to come up with a range of prices that might make sense to pay for this target business. They will normally use a range of valuation methods (DCF, asset valuation, comparable company analysis, and precedent transaction analysis) and look at these values side-by-side on a chart like this (called a football field chart):
Why do they do it this way?
Because these valuation methods are each attempting to assign value to the business from a different perspective. There is no way to know exactly—to the penny—what a business is worth to an acquirer. The goal with these valuations is to establish a range of values and see how these different valuation methods assign value based on their unique perspectives.
This is only part of the picture, however. If we’re looking at an M&A deal as something that will add value—meaning it will be profitable—we need to look at the role that negotiations play in this.
Once we have our established range of values, the negotiations will determine how attractive the deal will be. During these negotiations, the objective of the seller is naturally to get the buyer to pay them the most money possible. Meaning that they want them to make an offer towards the top end of their valuation range. Conversely, the prospective buyer wants to acquire the business for the lowest amount that the seller will accept.
If we determine that it is worth paying between $20 million to $30 million for a business and we get the deal done at $17 million, then from the acquiring business’ perspective the deal is extremely attractive. Compare that to another example where the seller won’t accept a lower amount than $35 million. This would be a very expensive deal for the acquiring business and there would be very little room for error when it comes to making the synergies from this deal profitable.
The point here is to understand the role that precedent transaction analysis plays in the valuation of a business.
Precedent transaction analysis is a form of relative valuation and this is considered less “precise” than some other forms of valuation.
We could compare this precedent transaction analysis to a DCF valuation as a good perspective shift. DCF valuations are a form of intrinsic valuation, which is a totally different perspective than the relative valuation perspective gained from analyzing M&A data. DCF valuations look at the business as an asset that will produce future cash flows and the idea there is to discount those cash flows back in time to their net present value. This is done to estimate the amount that it would be worth paying today for those future cash flows.
Precedent transaction analysis is more useful for adding perspective to our valuation. It’s a good way to factor in the markets demand for businesses like the one we’re valuing.
As we’ve already established, precedent transaction analysis is a form of relative valuation. Now we’ll compare it to comparable company analysis, which is another form of relative valuation; and we’ll explain the difference between these two common valuation methods.
Precedent transaction analysis looks at past M&A deals (completed deals) to see what acquiring businesses actually paid to acquire similar businesses. Precedent transaction analysis can be done with both public and private companies—we just need the data. Comparable company analysis is when we look at other similar businesses to the one we’re valuing that are publicly traded and we look to establish value relative to their financial metrics. The most common metric used here is price to earnings. Here, we’d look at what publicly traded companies that are comparable to the one we’re valuing are trading at above their earnings. Again, just like with precedent transaction analysis, we’d need to make sure the business we’re comparing it to has a similar business model, is of similar size, and operates in the same industry. If we go back to our example with the customer support ticket businesses, if one were publicly traded and the others were not, then we could look at that data and infer a relative valuation to the business we’re looking at.
So, precedent transaction analysis assigns relative value to a business from the perspective of past M&A deals; and comparable company analysis establishes relative value based on stock market trading data.
The rationale here is that those stock market investors value the business every trading day, when they decide to buy, sell, or hold stock in those companies. The price naturally fluctuates based on that trading. So, if investors are willing to trade based on those prices, then a relative valuation can be established.
As a caveat here, for comparable company analysis to be accurate, we need to account for the liquidity premium on the publicly traded company. Basically, the idea here is that investors would prefer to own shares in a publicly traded company because they are much more liquid than a minority ownership stake in a private company is. Investors can buy or sell stock on any trading day. The process of selling a stake in a private company is considerably more complex. To account for this, we discount that comparable company analysis data (called a liquidity discount) to more accurately reflect the market for a privately held business.
Now that we understand this distinction, let’s move on and look at some of the more common mistakes made when analyzing past M&A deals to find relevant data for precedent transaction analysis.
This section will highlight some common mistakes made with precedent transaction analysis.
As we’ve already established, the key to this valuation method is that the business we’re valuing is comparable to the one we’re getting the M&A data from. The businesses need to have similar business models (how they make money), they need to be of similar size (business life cycle stage), and they need to be in the same industry. Some buyers place a higher value on certain industries than others, because they grow at different rates. The main point here is that in order for the precedent transactions method to work, the companies need to be similar.
Additionally, we can rely more on recent M&A data than old data. If we’re selling a business, it’s an easy argument for us to make if the precedent M&A deal happened three months ago. That transaction was very recent and is much easier to justify than if it had happened in the 1990’s. The more recent the transaction we’re using, the more relevant the comparison is.
It’s also better if we have data from more sources. So, if we’ve seen two or three similar businesses sell, then we can justify this valuation more than if it’s just one business.
Here, we’ll quickly summarize some pro’s and con’s with using this valuation method for clarity purposes. Remember, ideally, we want to have a range of values established from different valuation methods rather than just from one.
Let’s begin by looking at the benefits of precedent transaction analysis.
First, adding relative valuations to the football field chart is always a good idea, and precedent transaction analysis is very useful to include if we can find relevant transactions. Normally, we start the valuation process with a Discounted Cash Flow (DCF) analysis. So, we benefit from adding in precedent transactions from the added perspective it gives us.
Second, the fact that we’re basing this on real world data (past transactions) is more trustworthy than some other valuation methods. As an example, asset valuations attempt to value the business based on its net tangible assets. The fact that the assets are worth $10 million on paper doesn’t mean that we can sell them for $10 million in a reasonable time frame. This is an issue that is commonly run into with liquidations. So, it can make good sense to trust a precedent transaction provided that it’s recent and the business is comparable because the deal did in fact close at that price.
Third, precedent transactions are extremely useful to reference in negotiations. Normally, precedent transaction analysis gives us a valuation on the higher side of our range. This is useful because it’s easy to make a strong case that the business is worth what another acquirer paid for a comparable company. This is especially true if we have more than one transaction to reference. So, seller’s can use this valuation method to argue that their business justifies a higher price.
Now let’s examine some drawbacks to the precedent transactions method.
First, on the same point as above, while it’s extremely useful to reference these past deals in negotiations, these valuations do tend to produce a valuation on the higher side of our range of values.
Why?
The vast majority of M&A deals involve competition—meaning more than one buyer will make an offer to buy the company for sale. Precedent transactions analysis looks at completed deals. Normally, the seller would accept the highest offer made. So, naturally precedent transaction analysis will produce a higher-end valuation. While this is good for the seller, it needs to be taken into account by both sides. A huge reason why M&A deals are deemed as failures (they weren’t profitable in the end) is that the buyer overpaid for them. This valuation method makes the assumption that the buyer’s decision to pay that precedent price was rational. It may not have been, or there may have been unique reasons why that buyer offered to pay more for the business.
As an example, say we have a new disruptive technology that’s changing the way business was done in the past in a particular industry. One buyer may just be interested in the growth potential of that new technology. Conversely, if another buyer were one of the larger businesses that this technology was disrupting, they would be highly motivated to acquire them. They could be made obsolete without the deal and would likely need to make the winning offer.
Second, the limited M&A data available for privately held businesses can make this valuation approach more challenging in some industries. Often information about these deals will surface, but it’s often up to the buyer how much data is released to the public. Additionally, there is more to the deal than the price. The terms of how that price is to be paid can vary widely and that information is harder to come by.
Third, due to the nature of valuing a business through precedent transactions, there will be an understandably small number of recent similar transactions to compare to in a lot of industries. This method is reliant on that data. Unlike a DCF analysis, which can be performed on any company that provides accurate financials, precedent transaction analysis is sometimes just not possible.
Regardless of the benefits and drawbacks to this valuation method, it is still desirable to include a precedent transactions valuation in the decision-making process. It adds meaningful perspective and helps both buyers and sellers to justify the deal in the end.
