At various occasions in the life of a business, the entrepreneur will wonder how much his business is worth. Whether when there is an equity transaction, on the arrival or departure of a partner or when a new shareholder comes along, or even to explore the possibility of selling a portion (or all) of the company… The valuation of the business will obviously be a subject of importance.
While there are many ways to put a value on a business, the subject may still create illusions and there are several misconceptions in this regard. Watching the Dragon’s Den or Shark Tank does not make you an expert! One aspect is often recurrent in these programs: the overvaluation given by the entrepreneur of his own company. In addition, the parameters that will be taken into account at the beginning of the life cycle of the company will not be the same when it reaches a certain threshold of maturity. Here is what I learned about the subject over the years as a result of different experiences (mine and those of other entrepreneurs around me)…
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Overvaluing the company has its longer-term traps
It is often thought that the value of a business is based on its turnover when this is only one of the variables that are taken into account. Of course, the revenues that a company generates can express the market and growth potential, but above all, it must translate into a potential to generate profits. Indeed, the probability of obtaining a return on an investment and the delays attributable to this return are just as important as the magnitude that this return can represent.
And, depending on the buyer, whether it is a participation or a complete acquisition of the business, the perception of valuation will depend on different factors. On the one hand, receiving shares of the company represents a taxable benefit, the valuation must then be the lowest. On the other hand, if you invest in a company, the cost of entry must be as low as possible and you hope to develop your assets thereafter. However, if the purchase price of the shares or the company is too high, it will be very difficult to obtain a return on your investment. Especially since the shares may subsequently lose value on the occasion of a future valuation that would be adjusted based on more objective and less speculative accounting parameters, as is often the case at the early stages of a company. In short, the buyer wants the lowest valuation possible while the seller wants the complete opposite, and with good reason.
There is therefore a bias that influences the judgment of the entrepreneur on the actual valuation of his assets. He is emotionally involved and interested, which explains the overvaluation that can result and the many transactions that will fail later. Have you thought about what might happen if you sell high-priced shares to a shareholder and want to buy those shares back a few years later, for whatever reason? You will then find yourself a prisoner of your own outbidding at the risk of making a potentially bad investment… Clearly, and fortunately, there are still reliable parameters on which one can rely and competent professionals to guide you.
The magic formula…
Over the years and through my personal experiences, I have seen several business valuation scenarios around me, and in different situations. One in financial difficulty, another with a demotivated entrepreneur, a business in full growth but with issues of profitability, a company looking for financing, offers of early or even very early participation in start-up, etc.
Of course, if the buyer perceives a high potential for synergy, he will take into account the annual revenues even more than another buyer. For example, the possibility of integrating the activities of the company he acquires into his own operations and thus of generating greater profitability potential with the integration. On the other hand, in the case of a buyer seeking to exploit the business in its current context and simply trying to increase its turnover, its evaluation will, in this case, really depend on the potential profitability.
Depending on the turnover, growth in recent years and projected growth potential, the multiplier may vary. But in short, here is a formula that is often used:
(multiplier x EBITDA) + entrepreneur’s marginal wages and benefits
EBITDA: Earnings before interest, taxes, depreciation and amortization. Its name is quite explicit since this indicator highlights the profit generated by the activity of the business independently of its financing policy (interest charges), its investment policy (depreciation) and its fiscal constraints.
The multiplier can vary according to the type of industry, the size of business, the level of maturity of the company, etc. For example, a stable company with low growth or declining revenues can be awarded a multiple of 3x or 4x while a company with high growth potential and synergistic potential can obtain a multiple of 7x, or more!
As in any transactional context where there is negotiation between a seller and a buyer, the motivation of each of them and the emotional factors will affect the outcome of a transaction and the price determined. It is therefore very variable and subjective, largely a question of supply and demand.
Therefore, as there are many factors to consider, this somewhat simplistic formula can always help the parties in an exercise to estimate the value and determine whether or not they wish to participate in further negotiations. Because, in reality, the sale of your business is a process that can be quite complicated and it is also a process that takes time… as we will have the opportunity to find out in an another article!