The Negative Impact of Unrealistic Sense of Valuation on Seller Outcomes in M&A: The Anchoring Effect

The anchoring effect is a cognitive bias. It is the tendency to rely too heavily on the first piece of information about a topic that is encountered (the anchor) when making decisions.

001

The Anchoring Effect

Deciding which advisory firm to choose is generally based on more than one factor, such as 1) experience in the relevant market, 2) chemistry between the owner(s) and the advisory team, 3) the thoroughness of process and competence of the advisory team, and 4) the initial thoughts on valuation the firm shares with prospective sellers. We challenge the latter (number 4 on the list) as a legitimate criterion for selecting your M&A advisor.

In fact, our advice is to beware of brokers, M&A advisors and investment banking firms who share your company’s valuation with confidence in their “sales pitch” when trying to secure your business. Initial discussions with advisors could and should contain information on the potential range of multiples (against revenue or EBITDA) that your business may be able to command when selling, based on recent, comparable transactions. However, emphasis is on the word “potential” as no two companies are alike, and markets can and do change. Therefore, even ranges are not definitive, and an advisor should share as much. The only way to know the range of values that interested acquirers would be willing to pay for your company is by running a full process with an experienced sell-side advisory team that drives competition for your business and guides the process.

Selecting an advisor who shares that they can get you X times EBITDA is likely not the advisor who will deliver optimal results for you. And it is not always a prospective advisor or investment banker who can plant an unrealistic seed in the mind of the seller. It could be a preliminary offer from one buyer that is not actually “real,” in terms that it is an offer that would never move to a successful conclusion/close. Or it could simply be the owner believing the business is worth more than it really is. These premature stated valuations, unreal offers, or assumed worth, as compelling as they can be, can do a lot of damage. This type of information becomes an anchor and anchors do not set up decision-makers (sellers, in this case) to make optimal decisions, and they often create unnecessary frustration.

The anchoring effect is a cognitive bias. It is the tendency to rely too heavily on the first piece of information about a topic that is encountered (the anchor) when making decisions. For this discussion, this anchor is an overstated valuation estimate. If anchoring is present, the seller uses this initial piece of information to make subsequent judgments - creating bias when interpreting other information in relation to the anchor that is not warranted. For instance, a confidently overstated initial estimate of a company’s value may make the seller interpret future, solid offers as ones that are under market, when they are not. This could lead to walking away from an optimal acquirer to wait for another offer with a higher valuation, that may not, and likely will not, come. In this example, the overestimated, inaccurate initial valuation estimate could result in a much delayed or a failed transaction. If a seller truly wants or needs to sell, this delay or truncated process can have significant downside for the seller and the employees.

The anchoring effect may also result in the seller thinking the advisory partner did not run an effective process when they have. A good process has the following elements: 1) well-developed, accurate and compelling marketing materials, i.e., the confidential information memorandum (CIM), 2) a comprehensive buyers list of strategic and financial buyers in the core industry and logical adjacent industries, 3) well managed communication with prospective buyers in the CIM review, management discussion and indication of interest (IOI) phases, and 4) strong guidance during letters of intent (LOI) negotiations and final deal structuring.

Bottom Line

An overstated preliminary estimate of valuation is NOT an element of a good process. Rather it’s an anchor.

A good advisor will help a seller avoid the anchoring effect bias in their decision-making before beginning and throughout the sale process.

Back to all insights

Jenifer "Jak" Kihm, PhD

Jenifer “Jak” Kihm has led successful engagements producing sustainable outcomes related to M&A integration, growth acceleration, talent acquisition, due diligence, and process improvement. She has an accomplished record of working with C-suite leaders to help optimize people, process, and systems for global brands.

Jak brings multiple perspectives to the firm having led large-scale M&A integration initiatives including a 22-company rollup, a merger of two $150M equals, and exit for the CapStreet Group of national brand Talent Tree, a Houston-based business services firm.

An industrial psychologist, she plays a vital role in applying and considering client objectives throughout the deal process, including negotiations.