Deal Pricing Is A Journey that Starts With Valuation

By Lior_Ronen | Founder, Finro Financial Consulting

Pricing and valuation are two things that get mixed up a lot, but they're actually very different.

When you sell a business, the price a buyer pays has little to do with the company's value. That’s because valuation is objective, and pricing is subjective.

Here’s an example:

You’ve probably seen it before.

One day, you buy a bottle of water at the local store at a certain price, and the next day you see the same bottle of water at a different location at a higher price.

Has something changed in the water? Probably not.

Has the production cost spiked overnight? Probably not.

So why did you pay a higher price for the same water bottle?

Probably because you valued the benefit you’ll receive from that bottle at a higher point than before. Maybe it’s hotter now, and you really needed some water.

Maybe you jogged, and that was on your route.

The value of the water hasn’t changed. It’s the same H2O. The only difference is the subjective added value you receive from the same water bottle in a different scenario.

This is the difference between valuation and pricing when buying an asset or investing in a business.

What is a Deal Price?

Many think that when a company sells equity in the business, they get a valuation and show it to the buyer, which is the price the buyer pays at the end.

In fact, it couldn’t be farther from the truth.

The first step in a deal is to set the ground for the initial deal terms. These initial terms are based on a third-party valuation that objectively estimates how much the business or the deal is worth.

The valuation process is typically performed using industry-standard mechanisms and methodologies following certain pre-defined and globally accepted principles.

That way, a discounted cash flow means the same thing everywhere on the globe, and everyone knows what steps the third-party valuation firm took to reach that value.

Or you know that the third-party valuation firm built a comps analysis to calculate that comparables valuation. That standardization is the backbone of an objective valuation and what makes it a must-have for every deal.

However, in some cases, you don’t want to pay what the business is worth. You want to pay as little as possible to defend your cash flow and improve your potential future return on the deal.

In other cases, you want to pay 10% or 20% above the valuation just to ensure you close the deal now or that the buyers will close the deal with you and not with another potential buyer.

In all of these cases, did you overpay or underpay for the business?

The answer is: you can never really tell. Because every party values different aspects and price them differently in the deal terms.

So, it’s all subjective anyways, valuation has no meaning. right?

Not exactly. Every negotiation needs a starting point.

When you set the starting point at a certain number, no matter what that number is, the other side will ask you why you picked that number. How did you get to it?

The answer most buyers and sellers are looking to hear is “by a third-party valuation.”

Usually, the seller will share its value estimates, setting the starting point for the price negotiation.

Buyers might be willing to pay more or less, depending on the important elements of every party in the negotiation. The price might not be the top priority but, in most cases, will be affected by every decision made in the negotiation phase.