During the course of a week, we talk to a lot of shareholders about their strategies, their objectives, and how they can start planning now for a future M&A event. One common point of discussion is always around valuation. There are many misapprehensions that shareholders have on this topic. In some cases it is wishful thinking applied to an arbitrary number, in others it’s simply misinformation. Following are some of the most common things we hear.
#1 – XYZ company is just like mine and I heard they got a 10x multiple. My offering is far superior to theirs, so I wouldn’t sell for anything less than at least that.
Even though companies can be in the same market and have similar offerings, no two companies are exactly alike. They are growing at different rates, they have different customer profiles and retention rates, they are generating different amounts and types of revenue, margins, and profits, they have different management and executive strengths, some are investor-backed / others aren’t, software solutions are never identical, etc.
A founder we recently talked to had a 20+ year old company doing under $15m in annual revenue. Based on our analysis, we suggested his probable strategic market enterprise value was likely to be in the range between just under 3x up to 4x revenue. He disagreed vehemently with our assessment, saying that one of his competitors had recently been acquired for $20B and “they are just like my company, except their solution isn’t nearly as good as mine”. He thought we were completely out of line.
It turned out the company in question had been around for under 10 years and had been growing ARR extremely rapidly YOY. They’d also received a big investment by a large private equity firm several years prior and had then gone on to not only smash organic growth but also do multiple strategic acquisitions, thus pushing their rate of growth and top line even higher. They were now global in scope with hundreds of employees and dozens of offices. They were generating about $5B in revenue at the time of the acquisition – an implied value of 4x revenue.
In reality, the only similarity the two companies shared was that they addressed the same market. Beyond that, they were very different companies in almost every respect: rate of growth, market reach, size, team, executive layers and experience, etc.
As an aside, in the mid-market especially, it’s very hard to obtain comparable deal information because more often than not, details aren’t made public. It’s a very opaque market. Valuation doesn’t tell the whole story. Just as important as valuation is the structure of the offer – how the valuation gets paid. Keep this mind the next time you hear someone say “I hear they got…” because only a portion may have been in cash with the balance in a hard-to-achieve earn-out, a note, or shares or some other structure.
#2 – I’ve invested over X number of hours / lines of code / years into this company, so I wouldn’t sell it for less than “inserts huge number”.
Buyers don’t value companies on this basis. But “it would cost them $XM to build this!” It may. And buyers do take into consideration what would it cost to build vs. buy. But most of the time this is not the metric that is going to drive a premium valuation.
Buyers pay premium valuations for companies that have top line revenue growth that is well above others in their market, a large % of recurring revenue, high margins, strong management teams, a growing and large total addressable market, enterprise clients, and high customer retention/low churn.
One additional note: companies that have been around for many years with only modest top line growth (or none at all) are viewed as lifestyle companies. There will still be companies interested in acquiring them, but they are unlikely to pay a premium valuation.
#3 – Our technology is far superior to anyone else’s in the market, so we know we’re worth a premium.
We often hear this from founders who are engineers and have invested all their time into R&D and none of their resources into sales and marketing. Growth has been lacklustre or even flat, but their reasoning for getting a premium valuation is that the buyer will already have a sales and marketing engine, so it will be “easy” for them to take our superior technology and grow it really fast.
The reality is that buyers want to see that you’ve got traction in the market. If you tell people that your coffee shop has the best coffee in town, there had better be a line up out the door to prove it. If there isn’t, buyers know there is an inherent problem in the company (usually in marketing and sales) that will require a significant investment by them to fix.
It’s an unfortunate truth that the best product doesn’t win. The best sales and marketing wins. Start selling more of what you have and move your focus away from R&D.
#4 – If someone with great marketing and sales buys us, our growth will take off!
Building on #3, there is not one company anywhere with talented marketing and salespeople sitting around just waiting to take on a new solution or services to sell. In fact, more often than not, most companies are running leaner than ever and trying to do more with less. Buyers want to see that you’ve built a great marketing and sales engine. If you haven’t, but your solution fills a gap for them, they’re unlikely to pay a premium when they know they will have to make a substantial investment in building out their sales and marketing resources to maximize their investment.
#5 – Why would I sell for a valuation of 4x EBITDA? If I just stay doing what I’m doing for another four years, I can easily make that plus I’ll still own the company.
Let’s go through the math on this. As an example*, let’s say a company is generating $3m in EBITDA and has a legacy solution (license and maintenance) or is primarily a services company with average top line growth, it’s likely to be valued based on EBITDA. If a buyer offers $12m to acquire the company, that suggests a 4x EBITDA multiple (businesses are valued on more than EBITDA; we’ve simplified this for our example). The after-tax proceeds, assuming a 25% tax rate, are $9 million.
If the owner keeps the business, the net present value of $3m EBITDA earned over the next four years assuming a 25% tax rate and weighted average cost of capital of 15% is $6.4 million. Unless the business is growing fairly quickly top and bottom line, this argument doesn’t add up. Not only that, but a lot can happen in four years: recession, much larger competitors moving into the space, new technologies disrupting the market, you lose your biggest customers, etc. so choosing to keep running the company comes at some substantial risk.
We’ve seen cases where owners received good offers but chose not to sell, only to find that once they were ready to do something several years later, they weren’t valued as highly as they had been previously. In some cases, even though their results were better, the market had taken a downturn, or their particular market was now more mature so there were fewer companies buying and valuations had declined. In others, the dominant players in their market had already acquired the companies they wanted, leaving fewer buyers, and fewer good quality buyers.
#6 – We Could Have Grown a Lot Faster, but We Chose to Keep Growth Modest and Focus on Profitability for a Better Valuation
This one falls squarely into the misinformation camp. In tech companies in particular, the biggest determinant of a premium valuation is top line revenue growth. If a company is growing significantly faster than its competitors, it is taking market share and clearly has some “secret sauce”. Buyers will pay a premium to access that growth – even though the company may be only marginally profitable (or not at all).
#7 – Our Offering is Unique – We Have No Competitors
There are only 3 scenarios in this case:
Most of the time, we are looking at #3. Assuming you have a viable solution and there is an addressable market of some size, a simple Google search will usually turn up many companies with similar offerings so instead of drinking this particular flavour of Kool-Aid, get serious about evaluating who is in your market and what differentiates your offering from theirs. There are very few serious market disruptors out there, and most of the time these companies are approached very early on by large Corp Dev teams whose mandate is to identify and invest in, or acquire, new and disruptive solutions that are a fit for their strategy.
#8 – Our Solution Would Be Great in the Hands of (insert tech company giant name here)
Building on #7, technology companies of any note are attuned to new technologies that come out. They will find you if you have developed something truly disruptive that is important to their strategy. If they haven’t come knocking, it’s likely they have no interest. This line of thinking often goes hand-in-hand with an inflated sense of valuation. It’s important that shareholders are realistic about how exciting their solution really is and who the potential buyers are likely to be.
#9 – We Believe We Can Achieve (insert unrealistic number) Growth Moving Forward
This is something we hear shareholders say once they learn what their probable range of market value is likely to be based on their current and past results if they were to explore their options today. If you’ve been running your company for 10 or 20 years and have been achieving fairly consistent single-digit growth YOY, how likely is it that you can suddenly achieve 20%, 25% or higher growth now? It’s better to be realistic and evaluate instead what your personal objectives and the market conditions are today, and whether you are ready to begin an exit now or whether you’re happy to keep working in the company and think about doing something at some point in the future. If you choose to wait, think about how any unforeseen market events might affect you and what your risk tolerance is.
#10 – Why Would I Sell Now? Everything is Going Great!
It seems counterintuitive, but the best time to sell (and achieve the best valuation) is when your results are trending up, there is increased M&A activity in your market (and the market overall), and you are under no pressure to accept any offers that you receive. Many owners miss their window of optimal opportunity by hanging in too long.
Markets are cyclical – it’s important to recognize when market conditions are good. It’s usually only in hindsight that we can see when a market has peaked, so trying to time for that is probably not realistic. Instead, look for signs that the market is strong: bullish stock market, confidence in the economy, and a sudden increase in unsolicited interest from potential buyers and investors.
Waiting until the economy is in a trough will have a negative impact on your valuation and the quality of buyers who are looking to do acquisitions.
Keep in mind that it takes 6 to 12 months on average to close a transaction and another 6 to 18 months where key shareholders will be needed in the transition when you are looking at planning for an exit.
#11 – I Don’t Need to Use an Advisor to Get the Best Outcome
This is a topic unto itself but the number one valuation enhancer is having multiple interested and qualified buyers submitting competing offers. By outsourcing the process to an experienced firm, you greatly increase the number, quality, and value of the offers that you will receive. Building on that, having a skilled negotiating team working for you will ensure that the offer you do accept is the best possible (both in value and structure) from the buyer you have selected. Getting deals done is hard. By outsourcing the process, you are able to continue to focus on growing your company so your results remain consistently strong from the time you begin a process through to signing the final agreements.
#12 – I Would Be Open to Selling if the Right Offer Came Along
Great offers never just “come along”. The likelihood that the best, most strategic buyer will step forward and hand you the best offer you could hope to get from any buyer out there is like expecting to win the lottery. It does happen but the odds are extremely remote. It’s certainly not a smart way to plan for a liquidity event or the next phase in your career. If you’re serious about exploring your options, then you should get serious about getting ready and doing it right.
If any of the above resonate with you and you’d like to understand what your market value is today, or how you can maximize your equity value for a future event, let’s have a call.
