Valuing Companies
"How much is my company worth?” It’s the most basic of questions, with many answers. The truth is that value is subjective. Ultimately, something is worth what someone else is willing to pay for it. And while valuation is only one component of an offer and subsequent transaction, it’s certainly a key piece.
THE QUANTITATIVE BASICS
The “transaction value" of a company is the total value of the business, including the operations and assets necessary to sustain on-going operations. Typically transactions are done excluding existing long-term debt, with working capital included.
The transaction value can be based on a variety of financial models. You may have heard of some of the following: "a multiple of earnings before interest, depreciation, and amortization (EBITDA)," "a multiple of EBIT," "a multiple of seller discretionary earnings (SDE),” or "discounted cash flow." All of these models, however complex they may sound or look in spreadsheets, seek to use the earnings power of the business, historical and/or forecasted, to determine a single number — the present value of future cash flows.
As you may have noticed, the models use a multiple of something. As any business owner knows, that “something" can fluctuate without affecting the value of the business — one-time expenses can make a business look less profitable and one-time revenues do the opposite. The trick is to determine what counts as earnings after one-time and discretionary costs and revenues have been removed.
There is no set multiple for a specific business, but you can get an approximation based on what other companies of similar size, industry, and business elements (i.e. leadership, financial consistency) have transacted for.
Once the enterprise value is determined, the deal comes down to what portion of the business is being sold and under what terms. It’s not uncommon for less than 100% of the equity to be sold, and for the seller to have a portion of the price earned out and/or a loan given to the buyer by the seller.
THE OTHER FACTORS
No two offers are created equal and every component comes at an opportunity cost. For instance, the more cash provided at closing, the lower the seller’s risk and the less the total transaction value. The more the seller is wiling to delay payment, or share risk, the higher the reward.
As a seller, it may be easy to get excited about a large figure, likely one of the largest you have seen since owning your company, but also remember to critically consider the offerer. There are countless questions to ask both of yourself and the potential investor in regards to financial capability, risk, short- and long-term return, transition timeline and requirements, employee value and cultural continuity, brand reputation, and legacy. Even if two investment firms offer you the exact same dollar figure, it is extremely unlikely they are making the same “offer."
HOW PERMANENT EQUITY VALUES COMPANIES
Permanent Equity values companies based on our investment approach. Unlike most investment firms, our capital is permanent and therefore our valuation must be based on the company's ability to operate indefinitely and generate earnings, rather than profiting from flipping the company to another buyer. This translates into our valuations generally being based on a multiple of owner earnings.
Owner earnings represent the cash available to the owner after all expenses, including things like necessary capital expenditures, have been paid. We apply a multiple to the owner earnings based on the durability, stability, and potential of the business. While our investment approach is not the same as traditional private equity funds, we are often competitive in valuation. The only exceptions are often high-growth organizations, or where another buyer sees strategic value in the assets.
Common multiple ranges in the types and sizes of businesses we consider are 3X to 6X. According to Harvard Business School's "The Market for Smaller Firms," “There are numerous profitable smaller firms in traditional industries with established business models and moderate growth prospects that routinely sell for EBITDA multiples of 4x to 5x.”
Whether we value a company at the low or high end of the range (or, occasionally outside of it), is determined by the situational factors of the particular business. For instance, a volatile financial history traditionally will earn a lower multiple, while a company with capable management in place will earn a higher multiple. While the math itself is not hard, the context is important; this is why we tend to ask lots of questions before offering our valuation.
VALUATION RESOURCES
Multiple organizations conduct studies and surveys of private companies to calculate what investors are paying for various types and sizes of companies. Given the difficulty of gathering private investment information, there is no one all-encompassing authority. The organizations listed below represent those we have found to be most reliable and reference most often.
Before digging into these resources, it is also important to remember that there is a huge population of companies not included: those that do not sell. Many companies seek a buyer and never find someone, whether a private equity firm or individual investor, willing to invest at agreeable terms. The population of companies included in these studies were attractive enough to merit investment from an outside party at terms agreeable to the seller(s).
Harvard Business School's "The Market for Smaller Firms"
Pepperdine University's Private Capital Markets' Market Pulse Reports
STILL HAVE QUESTIONS?
Curious how we would value your company? We are always happy to answer questions. Please feel free to email Emily Holdman at e@permanentequity.com. Or try our Instant Appraisal tool.