Show Me the Money: Understanding How Investors Value Your Business
Picture this: you’re casually scrolling through real estate listings, and suddenly, you stumble upon a property that catches your eye. The pictures look amazing, but here’s the big question: how can you determine if it’s a smart investment? Well, my friend, that’s where research comes in. Before you can confidently make a purchase, you’ll need to dig a little deeper to ensure the price is fair and it’s the right fit for you.
Believe it or not, the process of evaluating a property isn’t all that different from what investors go through when they consider investing in businesses. Before any deal can be sealed, both the investors and the business owners must agree on one crucial detail: the valuation.
Valuation can be a tricky subject because there are potential upsides and downsides to every investment opportunity. Business owners and investors sometimes find it challenging to reach a consensus on a specific valuation. However, if you understand how investors evaluate businesses, it can help you prepare for discussions and secure the best possible deal.
Let’s dive into the fundamentals of valuations. To make fair comparisons between different businesses and industries, investors use a common financial metric to value a business. It’s relatively straightforward to determine the financial value of a publicly traded business since the share price multiplied by the number of shares gives you the equity value. The stock market provides a public consensus on share value, also known as the ‘market price.’
However, valuing private businesses requires a different approach. Both the owner and the investor need to find a common language to discuss the valuation. One popular method for valuing private businesses is the EBITDA multiple approach. EBITDA (earnings before interest, taxes, depreciation, and amortization) gives a snapshot of the business’s operational performance. It serves as a good proxy for the cash flow that the business can generate before debt servicing requirements, especially for businesses with low capital expenditure.
The EBITDA multiple is a number applied to a company’s EBITDA to calculate the Enterprise Value, which represents the total value of a business. Think of it as the price tag of a house. It includes the equity value (value attributable to shareholders) and net debt (total debt minus cash).
Investors set an EBITDA multiple based on their research into the business’s risk-to-return profile. There are several considerations they take into account, such as industry trends, growth potential, legal and regulatory issues, and how the business positions itself in the face of challenges. They also compare the business to similar ones in the market, evaluating factors like competitive position and growth rates. Additionally, investors delve into the finer details, analyzing the leadership team, revenue projections, profit margins, and customer concentration.
Now, let’s talk about ‘normal’ valuation multiples. The EBITDA multiple represents the number of years of future earnings an investor is paying for today to acquire a stake in the business. Multiples can vary depending on factors like the industry and its capital investment requirements. For example, industrials typically have lower multiples due to significant capital investment needs and lower profit margins. On the other hand, healthcare often has higher multiples due to its resilience and consistent demand. Software companies, with their high margins and rapid revenue growth potential, can command higher multiples.
Finding alignment between investors and business owners regarding valuation isn’t always easy. In such cases, financial instruments like convertible notes can bridge the gap, allowing flexibility in initial valuation and offering a discount on future valuation. Building a relationship with potential investors before seeking capital can help establish alignment and confidence. Time spent understanding each other’s perspectives and thoroughly evaluating the internal and external factors impacting the investment decision is key.
Researching valuations achieved by competitors or similar companies and seeking insights from previous portfolio companies can provide clarity and assurance. Remember, it’s all about creating a strong foundation for your business’s growth and making the right moves when engaging with investors.
TL;DR: Just like you research a property before making a purchase, investors evaluate businesses before investing. Valuation plays a crucial role in reaching an agreement. Understanding how investors evaluate businesses can help you prepare for discussions and secure the best deal. Factors like industry trends, growth potential, and business performance impact valuations. EBITDA multiples are often used, and they vary across industries. Building relationships, conducting thorough research, and seeking insights can lead to alignment with investors and promote your business’s growth.
