An intuitive approach to start-up and SME valuation
From the elegance of valuation theory to the hard truth of reality
Valuation is an interesting and complex topic indeed. The theory behind modern valuation approaches is fascinating, hard to grasp, and even harder to apply to real life projects.
Everyone working in corporate finance, Merger & Acquisition or Private Equity Investment have heard of and understand at the very least the basics of the different valuation methodologies commonly used: Discounted Cash Flow analysis, Comparable Transactions, Industry average EBITDA or Revenue multiples.
However even if one was to master the theory, implementation of these techniques remains challenging. In a world of uncertainty, how to decide on what discount rate or WACC to use? How do you know for sure on what multiple of EBITDA you should base your valuation of that small caps, innovative privately owned company you are about to invest in?
The simple answer is: you cannot. There is no such thing as a “true and only” firm value. It is no wonder why even within the valuation teams of the best consulting firms in the field everyone agrees that valuation is not a science, but an art.
Then what do you do with that? How do you get some comfort around the valuation you are going to offer? How do you make sure that if you strike a deal, it will be at a value you are comfortable with?
The answer is: rationalization. Whatever valuation method you decide to use, your model will be as good as your assumptions, and you’d better make sure that you are comfortable with your assessment of the investment target and with how you translate this assessment into a nice and robust priced offering.
Helping you place the cursor in your Revenue or EBITDA multiple range
I would like to introduce here an approach to rationalize your view and opinion that I have used several times in the past while valuing innovating SaaS companies at HoriZen Capital or helping clients with their modelling and fundraising processes.
Overall, please keep in mind that when trying to value a company, I would always recommend to first try to come up with a valuation range, not a straight value, comparing and combining different methodologies. I have built a model that you can find on Eloquens that does just that, also checking for each output that the result is consistent with market practice. However, when you’ll submit your Letter of Intent (LOI), you will need one number, and one number only.
Here I will assume that you have done your research and have a rough idea of the range of Revenue / EBITDA (or any other aggregate) multiple that the market is generally paying for the industry in which your investment target operates and I’d like to suggest an approach to help you narrow down the multiple that should best apply to your specific case.
Leveraging your analyses of financials and operation metrics
If you have got to the point where you are willing to make an offer, it should mean you already have a decent opinion of the different aspects of your target business. At this stage you should have had access to financials and operational metrics like customer churn, have done at least a rough assessment of total addressable market, understand the quality of the team, know the company’s revenue streams and client typology.
If you’re unsure how to analyze these financials and how to conduct proper Financial Due Diligence, you can check out the step by step Financial Due Diligence course I’ve created.
Wouldn’t it be just great if instead of a wild guess of how all this information should come together and impact your offered multiple you could have a more systematic, rational approach?
Selecting the key success factors that you think are relevant
What we do when we look at investment opportunities with the HoriZen Capital team is that I first lay out the key elements of the target that we think should have an impact on valuation. These can be pure financials ratios like EBITDA %, LTM revenue growth or EBITDA to Cash ratio but although broader characteristics that we think are good indicators of the risk profile of the company, like years in business, level of seasonality or client base diversification. It will also include elements that are more subjective but still play a huge part in our decision whether to make a deal or not: Quality of Management, scalability of the business, product level of disruption and anything we judge relevant.
Once all these elements are laid out nicely in a clean spreadsheet you can now grade each of these success factors on whatever scale you are most comfortable with (eg. 1 to 5, 1 to 10, -10 to +10, your choice). And since it’s likely that you consider some elements should have a higher impact on your decision (eg. Quality of Management is often quoted as a top priority) you can include a row in which you will assign a weight to each of the success factors you have designed. Finally, you should be able to calculate an average weighted grade for your target and use a simple linear function to see the corresponding multiple based on your range. For example, if you use a range of Revenue multiple of 1.5x up to 2.5x, and that your average weighted grade is 5/10, your corresponding multiple will be 2.0x.
Here is an example of what it could look like:
Together with the team at HoriZen Capital, using this exact same methodology we have built an assessment model comprising a dozen of success factors that we have selected from our experience as investors and SaaS brokers. This allows us to have a more systematic approach on how we value our investment opportunities and we believe it helps us being wiser investors.
In the end, you won’t know THE truth, but you will get closer to yours
It would be wrong to say that this methodology will provide you with an objective, unbiased valuation of a business. Every grade and score are based on your own subjective perception of how it should impact total value of the business and is only reflective of your own view. However, it gives you a powerful tool to synthetize your overall opinion of your target and gives you a simple but robust way to convert your perception into a clear number.
Looking for robust financial models and best practices? Please have a look at my Eloquens Page! You’ll find models to help you value your business, manage your inventory, better understand your pricing strategy and much more!