An interesting phenomenon is when investors agree on valuation but incorrectly attribute the source of the valuation. The result is that incoming investors or buyers of the firm end up paying the sellers for value that the buyers create.
A common occurrence is when a start-up sells out to a major player, especially in the services industry. Imagine that there is a local start-up, which we will call Triangle, sells a particular service offering into the market.
Suppose that Triangle has built up its business until it is the dominant player in MENA. In such situations there are usually global players which would be much larger than Triangle but have not yet been able to penetrate the MENA region. Let us call one such player Rectangle.
What happens repeatedly in such situations is that when the business managers in Rectangle look at Triangle one of the first things that they see is that the prices that Triangle charges are far below those of Rectangle. The difference, of course, is the value of the Rectangle brand which allows it to charge a higher price for similar service.
When Rectangle decides to try to acquire Triangle there will invariably be a debate over the valuation of Triangle. The valuation discussion will centre around the revenue growth of Triangle.
At some point one of two things happens. Either the management of Rectangle get tired of the negotiation, realise that they can immediately increase the value of Triangle post acquisition by increasing the price of the service to that of what Rectangle charges under its own brand.
Alternatively, if Rectangle’s management do not reach the aforementioned conclusion on their own a smart investor in Triangle might float the idea.
Either way the end result is that the management of Rectangle end up increasing the purchase valuation of Triangle not because of the belief in the increase of value inherent to Triangle but because Rectangle can increase the value due to the value of their own brand.
Let me be clear about what this means: Rectangle are paying the shareholders of Triangle for value that Rectangle is creating. Usually Rectangle will never realise their error because they will end up making a lot of money leveraging Triangle using their brand.
Frightening, isn’t it?
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