In the sale of privately held businesses there seems to be no mechanism and certainly no attempt on the part of buyers to account for the selling company's growth rate. In the public market this factor is widely recognized and is accounted for with an improvement on the PE multiple, the PEG or Price Earnings Growth multiple. Because there is no exact translation between EBITDA multiple (the primary valuation metric for privately held companies) and Earnings Per Share and PE multiple (the primary valuation metric for publicly traded stocks), the purpose of this article is to try to calculate an adjustment factor that can be applied against the EBITDA valuation metric in order to present a more accurate accounting for differences in growth rate for the valuation of privately held companies.
Experienced
business buyers are masters of setting the rules for how they calculate the
value of a business they are attempting to acquire. You may think that a 5 X
multiple of EBITDA or 1 X Sales would be pretty cut and dried, but in practice
it is open for creative interpretation. For example, if you just had your best
year ever and your EBITDA was $2 million and the market valuation was 5 X, then
you would expect a $10 million offer. Not so fast. The buyer may counter with,
"That last year was an anomaly and we should normalize EBITDA performance
as an average of the last three years." That average turns out to be $1.5
million and like magic your purchase offer evaporates to $7.5 million. On the
flip side, if you just had your worst year at $1 million EBITDA, you can bet
the buyer will use that as your metric for value.
The three
owners paid themselves $100,000 each in salary, but the buyer asserts that the
fair market value salary for a replacement for each senior manager is really
$150,000. They apply this total $150,000 EBITDA adjustment and your valuation
drops by another $750,000. If the family owns the building separately and rents
it to the business for an annual rent of $200,000 when the FMV rental rate is
$300,000, the resulting adjustment costs the seller another $500,000 in lost
value.
Another
valuation trap for a seller is that they want to hire additional sales
resources to pump up their sales just prior to the sale. This is almost always
a bad move. Most technology sales reps take a year or longer to ramp up to
productivity. In the interim, with salary and some draw or guarantee, they
actually become a drain on earnings. The buyers do not care about the
explanation, they just care about the numbers and will whack you with a value
downgrade.
The least
understood valuation trap, however, is there seems to be no mechanism and
certainly no attempt on the part of buyers to account for the selling company's
growth rate. In the public market this factor is widely recognized and is
accounted for with an improvement on the PE multiple, the PEG or Price Earnings
Growth multiple. The rule of thumb is that if the stock is valued with a PEG of
less than 1 then it is a good value and if it is over 1 it is not as good.
Because
there is no exact translation between EBITDA multiple (the primary valuation
metric for privately held companies) and Earnings Per Share and PE multiple
(the primary valuation metric for publicly traded stocks), please allow me a measure
of imprecision in my analysis. My purpose is to try to calculate an adjustment
factor that can be applied against the EBITDA valuation metric in order to
present a more accurate accounting for differences in growth rate for the
valuation of privately held companies.
I have
chosen two stocks for my analysis, Google and Facebook. The reason I choose
these two is that they are widely known, very successful, in the same general
market niche, and are at different stages of their growth cycle. Google sells
at a PE multiple of 33.37 while Facebook sells for a PE multiple of 113.71. The
PEG of Google which = PE Multiple/5 year growth rate is 33.37/16.85 for a PEG
of 1.98. I actually backed into the growth rate using the readily available PE
multiple and the PEG from my Fidelity account.
Facebook
sells at a PE multiple of 113.71 and has a PEG ratio of 3.62 (may be some
irrational exuberance here), which translates into a 5 year growth rate of
31.41%. For our comparison we should also include the average PE multiple for
the S&P 500 of about 15. Let's make the assumption that on average, this
assumes that these companies will grow at the growth rate of the U.S. Economy,
say 3%.
So to
calculate a normalized PE ratio for these two companies, we are going to create
an adjustment factor by dividing the 5 year compound growth rate of Google and
Facebook versus the anticipated 5 year compound growth rate of the S&P 500.
For Google the 16.85% growth rate over 5 years creates a factor or 2.178 or a
total of 217.8% total growth over the next 5 years. The S&P factor is 1.16.
So if you divide the Google factor by the S&P factor you get 1.878. If you
multiple the market PE multiple of 15 by the Google factor, the result is a PE
of 28.2. Not too far off from the current PE multiple of 33.37
Facebook is
a little off using this method resulting in a normalized calculated PE of 50.65
versus their current rate of 113.71. This will appropriately seek a level over
time and settle into a more rational range. My point here is that the public
markets absolutely account for growth rates in the value of stocks in a very
significant way.
Now let's
try to apply this same logic to the EBITDA multiple for valuing a privately
held technology company. If the rule-of-thumb multiple for your company's
valuation is 5 X EBITDA but you are growing at 10% compounded, shouldn't you
receive a premium for your company. Using the logic from above we assign a 3%
compound growth rate as the norm in the 5 X EBITDA metric. So the 10% grower
gets a factor of 1.61 versus the norm of 1.16. Dividing the target company
factor by the normalized factor results in a multiple acceleration factor of
1.39. Multiply that by the Standard 5 X EBITDA multiple and you get a valuation
metric of 6.95 X EBITDA.
A little
sobering news, however, you will have a real challenge convincing a financial
buyer or a Private Equity Group to veer to far away from their rule of thumb
multiples. You will have a better chance of moving a strategic technology
company buyer with this approach. A
discounted cash flow valuation technique is superior to the rule of thumb
multiple approach because it accounts for this compound growth rate in
earnings. If the technique produces a higher value for the seller, the buyer
will keep that valuation tool in his toolbox.
Perhaps the
best way to negotiate a projected high growth rate and translate that into transaction
value is with a hybrid deal structure. You might agree to a cash at close
valuation of 5 X EBITDA and then create an upside kicker based on hitting your
growth targets.
So for example, your EBITDA is $2 million and
your standard industry metric is 5X EBITDA. You believe that your 10% growth
rate (clearly above the industry average) should provide you a premium value of
6 X. So the value differential is $10
million versus $12 million. You set a target of a 10% compounded growth in
Gross Profit over the next 4 years and you calculate an earn out payment
methodology that would provide an additional $2 million in transaction value if
you hit the targets. It is a contingent payment based on actual post closing
performance, so if you fall short of targets you fall correspondingly short on
your earn out. If you exceed target you could earn more.
Successful
buyers do not remain as successful buyers if they over pay for an acquisition.
Therefore, the lower the price they pay, the greater their odds of chalking up
a win. This is a zero sum game in that each dollar that stays in their pocket
is one less dollar in your pocket. They will utilize every tool at their
disposal to convince the seller that "this is market" or this is "how
every industry buyer values similar companies." It is to your advantage to help move them
toward your value expectations. That is a very hard thing to accomplish unless
you have other buyers and can walk away from a low offer. Believe me, if they
are looking at you, they are doing the same dance with at least a couple of
others. You must match their negotiation leverage by having your own options.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. Please visit our Web Site MidMarket Capital