Methods of business valuation in the sale of a company
How much is a company worth? This is the key question in company sales and equity financing and is a concern for entrepreneurs, investors, and shareholders.
There is no objectively correct company valuation as this will differ depending on the valuation event and the peculiarities of the company: Are we talking about a company sale, the involvement of investors or special situations such as the exit of individual shareholders? What are the specific characteristics of the company?
In this article, we have summarized relevant business valuation methods, factors that influence a valuation and ways to optimize the business valuation.
Overview of business valuation methods
Business valuation methods are typically divided into net asset value methods, capitalized earnings value methods and market value-oriented methods.
The net asset value method only considers the value of the company’s components and is most used when future entrepreneurial activity is no longer relevant. This can be relevant, for example, in the case of (impending) insolvency or the planned break-up of a company. The continuation and thus the future earning power is not relevant, and the focus is on the assets of a company. Relevant assets can be, for example, real estate, machinery, intangible assets such as intellectual property, inventory, etc. The buyer of a company would be able to recover the paid purchase price simply by liquidating the assets. In the case of a company sale, the net asset value is thus the lower limit of a possible purchase price. If the net asset value has been correctly determined, there is practically no risk for the acquirer to make a bad deal.
Whenever the company is expected continue as a going concern, the capitalized earnings method is more appropriate, since the focus lies on the company’s ability to generate future profits. For small companies, the projected earnings for a year would be calculated, for example, by taking an average of the pre-tax earnings for the last three years and the projected earnings for the next three years. This is divided by a capitalization rate, which could typically be around 15-20% for small companies. An average income of 200,000 per year and a capitalization rate of 20% would thus result in a company value of one million euros.
For larger companies, a more complex discounted cash flow method is appropriate (see below). In both cases, however, the future development of the company has to be forecasted, so the risk of being wrong increases compared with the net asset value method.
In the case of sales of medium-sized and larger companies, as well as in the discussion of M&A scenarios, market value-oriented methods and the DCF method play particularly important roles. Therefore we present these in more in detail in the following. Our aim is to provide a practical description of the methods, rather than a presentation of all the details.
Valuation procedures in practice
When selling a company, the interest of the buyer determines the price he is willing to pay. The final purchase price for a company may differ from the company value – however this is determined. A well-structured, competitive sales process or a buyer’s specific strategic interest can have a strong influence on the purchase price. To properly prepare for negotiations, the seller should think about the possible valuation of his company in advance of the sales process. The following methods can be used to determine a company valuation:
Multiples on sales or earnings ("transaction multiples")
For this method, valuations from comparable transactions are set in relation to the sales and/or earnings of the company sold. EBITDA, and in some cases EBIT, is often used as a measure for earnings. The resulting ratio is called “multiple”. A company’s valuation corresponds to e.g., 1.5x the company’s sales or 10x the company’s EBITDA. Using EBITDA as a reference makes sense, as the capital structure of the company and its taxation should not affect the value of the company.
The advantage of this approach is that it is easy to understand. It is clear to everybody that a higher multiple corresponds to a higher valuation. The challenge with this type of company valuation, however, is to find truly comparable transactions, especially since in most cases transaction data is not disclosed at all. In addition, public transaction data is generally biased, as investors and sellers are more willing to disclose data on transactions with higher valuations. In contrast, so-called “fire sales” or low valuations are often not discussed. Average company valuations based on public information are therefore systematically overestimated.
Moreover, multiples are only meaningful if the companies are comparable to some extent in terms of positioning, revenue growth, technological USPs, etc. In most cases, therefore, multiples only serve as a reference and do not allow a clear statement à la “in this industry, companies are valued with a sales multiple of X”.
The valuation of listed companies ("public comparable multiples")
Theoretically, valuations of listed companies are an ideal reference point for a company valuation. They are very easy to track since the information is disclosed and available to everyone. However, listed companies are almost always much larger and better established than the companies being evaluated. Larger companies usually have a significantly higher multiple than smaller companies and the valuations can only be compared to a limited extent.
Nevertheless, it is interesting to look at these multiples as they provide an estimate of the maximum purchase price from the point of view of a listed, strategic buyer. If a listed company is valued at a certain multiple, it is in a good position to take over a smaller competitor valued at that same multiple – to put it simply. On the other hand, the buyer will shy away from paying a much higher multiple for fear that the stock market will react negatively. These are of course simplified considerations and in individual cases other factors may lead to different valuations.
Discounted cash flow approaches
The analysis of expected cash flows resulting from a business is theoretically the most sound approach to valuing a company. Ultimately, every business valuation is based on the expectations of the buyer or investors about the future development of the company’s financials. A DCF model incorporates the initial investment (as a negative cash flow) and the expected positive cash flows in the future. The so-called terminal value, i.e. the value of the company in e.g. ten years, is also taken into account. All future cash flows are discounted to consider the cost of capital and the risk of negative changes in the planning.
However: the values included in the planning are, without exception, uncertain forecasts. To account for this uncertainty, investors apply high discount rates. Overall, the DCF model is also the easiest to manipulate. If, for example, the discount rate is turned up by a little or the terminal value is derived from too positive assumptions, then the present value i.e., the company valuation today, changes extremely.
The DCF model is nevertheless an interesting reference, as it requires one to take a deeper look into the future and the potential of the company. The buyer can analyze the underlying assumptions and decide whether the company value is justified.
In addition, the venture capital method is sometimes mentioned in the literature. This method combines DCF and market value methods. Since it is hardly possible to value a start-up with traditional methods alone, venture capitalists try to simulate the development of the start-up up to a potential sale. They combine a DCF model with possible exit multiples to decide whether the investment is reasonable given the underlying assumptions.
Different reference values form a valuation corridor
A professional analysis of a company’s value should always include various approaches. The result of such an analysis will not be a single company value, but rather a valuation corridor backed up with arguments. This way, the seller has an initial understanding of what to expect in a sales process. And he/she is better prepared for negotiations with a buyer.
The main factors influencing company valuation
The methods described above provide a valuation indication or show a corridor in which the company value should lie. But which factors influence a company valuation? On what grounds will a valuation deviate upwards or downwards?
The valuation of larger companies is generally higher than that of smaller one. This is driven by factors such as greater market power, a proven business model, (international) reach, and overall lower risk for the investor or buyer. The impact on valuation can be extreme if size falls below a certain threshold. For example, a profitable technology company with € 2-3 million in yearly sales will typically achieve at most half the earnings multiple as a similar company that generates € 20-30 million in sales.
Growth above all
The most important factor influencing a company’s valuation is usually its growth rate. High growth rates create high expectations: if a company grows at a rate of 100%, its value will at least double in one year time, quadruplicate in two years, and so on. For these high expectations, investors will be willing to pay extremely attractive valuations. In somewhat simple words, buyers and investors fear that they might miss the right timing for an investment – the company may eventually become too big and too expensive for a takeover or investment.
A strong management
The management team also plays a major role in business valuation. This becomes most evident in the case of succession. If this is not properly prepared or still unclear, buyers will not be willing to pay an attractive valuation. The inherent uncertainty and the need to find new solid managers is reflected in the valuation. For financial investors who do not have fitting management in-house, this issue is often a showstopper.
Interesting market - interesting price
Company valuations vary widely across industries. This reflects the estimated attractiveness of the industry, current market dynamics and future opportunities. For example, a well-functioning software company will almost certainly achieve a better company valuation than a similarly sized, well-functioning service company. The software company is more likely to be attributed better growth and scalability potential.
Business model - the flavor of the month
Next to the industry, the business model of the company is also decisive for its valuation. In recent years, for example, software-as-a-service (SaaS) models are often preferred over companies that sell software in traditional licensing models. Recurring revenues are valued at significantly higher multiples than one-time-revenues.
It is to be noted, however, that there is sometimes a tendency towards a somewhat bizarre twisting of the facts: traditional service providers are categorized as “business process outsourcing companies”, while companies offering 12-month contracts market themselves as “recurring revenue” business models. A professional advisor can help in building a strong business case without making inappropriate claims. During the M&A process, inaccurate claims will likely be uncovered, and might even be detrimental to the process and discredit the entire “storyline”.
How to achieve a better business valuation
As listed, the value of a business is the price the buyer is willing to pay. That’s what makes it so important to properly prepare for the sale of a business:
Give buyers the information they need to motivate an attractive valuation
Many sellers underestimate the information asymmetry that exists in the context of a company sale. They know their company, its potential, know that it is well managed, etc. The art of selling a company is to prepare this information from the buyer’s point of view, to present the core value and the potential of the company. One of the most important tasks of an M&A advisory is to illustrate the key value drivers and to build a strong case for a high enterprise value.
Prepare for the valuation discussion
Involve an expert who can run you through various valuation approaches and scenarios and, depending on the buyer, consider synergies and strategic aspects. You will most likely be negotiating with experienced professionals on the buyer side – make sure you have an eye-to-eye discussion.
The purchase price for a company will be higher if several potential buyers are interested in it. This way, the willingness to pay of individual buyers can be fully leveraged. The likelihood that a transaction will be completed on terms favorable to the seller increases as well.
Build bridges in case of valuation differences
If the buyer and seller’s valuation expectations lie very far apart, it is often not feasible to find a quick compromise. Instead of trying to “meet in the middle,” it may be helpful to think about a change in the transaction structure and to propose alternatives.
Some buyers, for example, might offer better conditions if the seller contributes part of the acquisition financing (so-called “vendor loan”). Variations in the valuation can often also be achieved by modifying the structure of purchase price components. Experienced advisors will be able to assist you in defining a transaction structure and, owing to their experience, will be in a better position to argue this to a buyer.
The more professionally a transaction is prepared and executed, the less likely it is that downstream valuation discussions arise. Some buyers may be tempted to renegotiate the price shortly before closing a transaction. This can be prevented by rigorous management of the entire process. The buyer must also be made aware that he is not the only interested party for this company.
It is also very helpful to include positive business news in the process. The buyer will always be interested in how the business is doing and will typically ask for up-to-date numbers on a regular basis – even moments before a scheduled notary appointment. The seller needs to communicate clearly that they are on track with their plans and that there is no uncertainty about their business.
The valuation is not everything
In addition to the actual company valuation, however, there are other levers that are of relevance to the seller. If the topics “working capital” and “normalizations” are poorly prepared, money will be given away for no good reason.
Optimization of working capital
In most companies, capital is tied up in business operations. Customers pay later than supplier invoices must be paid, a certain amount of inventory is necessary, etc. In almost all transactions, the buyer will assume that a certain level of working capital will remain in the company, and in case of negative variances, this amount will be deducted from the purchase price. If working capital is optimized in time, this corresponds to a direct increase in value for the seller. However, this should be addressed well ahead of a transaction, at the latest 6-12 months in advance.
Normalization of expenses
Expenses that have been incurred in the past but are not expected to be incurred in the future can be eliminated. Such items of normalization include M&A transaction costs, costs for one-off legal disputes, special one-off investments or other extraordinary expenses. Above-average compensation for company owners that will no longer be incurred in this form after a transaction can also be factored out. This increases pro forma profitability and improves the basis for a valuation. However, these normalizations must be performed before a buyer is provided with figures or a financial plan.
Guarantees and Co.
Certain legal terms can quickly turn an offer that is attractive in terms of valuation into an offer that is overall unattractive. For example, the seller must always provide guarantees when selling a company. Guarantees can differ massively in their form and with regard to the consequences of a breach.
The terms of a transaction must be considered as an overall package. In addition to the guarantees, these can include payments into an escrow account or compensation for management after a transaction.
About Quantum Partners
Quantum Partners GmbH, headquartered in Munich, is a specialized corporate finance advisor that supports clients in company transactions as well as in finding financing.
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Company valuation methods are essentially a) net asset value methods, which are based on the total assets of a company, b) capitalized earnings value methods, in which the profits generated in the future are forecast and valued, and c) market value methods, in which the transaction valuations of comparable companies are used.
Depending on the occasion, business valuations are performed by different parties or market participants. Examples: In the case of a planned acquisition, the buyer will either value the target company itself or with the help of external specialists. The shareholders of this company will also want to form an opinion about the valuation of their company. If the sale of the company is organized within the framework of a professional M&A process, the M&A consultant will provide his clients with appropriate valuation indications.
The most important occasions for a company valuation are company sales (M&A transactions), investments in a company or the sale of company shares, e.g. when individual shareholders leave the company.