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.

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.