A Business Valuation May Not Accurately Reflect a Software Company's Value

I can't tell you  the number of times I have talked with owners of software companies that are very disappointed with a valuation performed by a qualified valuation professional. The purpose of this article is not to disparage this fine profession, but to point out the limitations of a process based on quantifiable metrics. Those metrics, industry comparables or Comps, and discounted cash flow are excellent valuation approaches for most traditional businesses. In addition to these metrics, many industries  have established rules of thumb for valuations like 4 X EBITDA or 70% of the trailing twelve months' revenue. 

If these metrics accurately function universally over a broad range of businesses, why don't they work for software companies? The most compelling difference is the exponential nature of the leverage of technology.  In its most basic form, if you are making Widgets, to make your next Widget, you need the same amount of material, labor and capital. Yes, you can achieve some economies of scale, but those improvements are linear. This limitation naturally results in a narrow range of potential business valuation multiples.

Let's compare this with the exponential scalability of software assets. Once the software is written and stress tested by a core group of users, the cost for the next unit sold is almost $0 for a digitally duplicated copy that is downloaded. To go from 100 users to 1 million users will require more staff, but it is not even close to the additional resources required for the same scaling in the manufacturing, distribution, services or retailing environment. 

Software company owners that are approached by strategic buyers generally do not do a very good job of positioning their company to drive this strategic value. They will usually start with the argument that  IBM or Microsoft or Google bought XYZ Competitor with $300 million in revenues for $1.2 billion. My company that is in the same space with sales of $3 million should sell for $12 million. The valuation of a large, brand name competitor  is not translatable into a valuation for a small unknown company that provides a similar software. The buyers all know this and can immediately dismiss this potential seller as unrealistic.  

Another limiting factor in the valuation puzzle is that finding relevant comps is very difficult with unique, small private companies. Privately held business owners do not want the public to know what they sold their company for and do not authorize the publication of that information. Unless the transaction is an acquisition by a public company and the deal value is large enough to be material and is required to be reported, no information about the transaction will be publicly available. So you can get the information on the $1.2 billion transaction but generally will not get the metrics on a $10 million deal. We are now back to the problem of the large company metrics that are not applicable to the very small company valuation.

In the discounted cash flow model, the analyst must project the cash flows out for five years and longer. To see the classic hockey stick growth actually captured in a financial model is an outlier for a typical valuation model. When a buyer analyzes this model they are generally resistant to accepting the high double digit or triple digit growth rates required to get the valuation that the owner deems appropriate.

Software company owners often put me on the spot and ask me for my opinion of value. I almost feel like the two realtors competing for a listing where the ethical guy says your house is worth $925 K and the other guy says he can get $1 million. The seller picks the $1 million realtor and then the overpriced house sits on the market for eight months before being sold for $880 K. The ethical guy could have sold it in three months for $925 K.

A software business is way more complex. Even though I am flattered that the business owner is inviting my opinion, my answer is not supportable from a classic valuation metrics standpoint. I will rely on my experience with selling similar types of companies, the level of acquisition activity happening in the space, the value of the contractually recurring revenue, the availability of similar companies that could be substituted, the uniqueness of the solution, the sales resource required to scale, the time and cost to develop the solution internally, etc. We create a teaser and a memorandum where we package and highlight the strategic value drivers to the potential buyers.

When you see these high profile technology acquisitions and see that a relative start up with no profits and limited sales was acquired for $250 million by Tech Giant A, do you think they just picked that number out and said to the seller, here you go? It looks easy and glamorous, but if the acquirer could have paid $5 million, they sure would have.  What was going on behind the scenes was the equivalent of a championship boxing match of M&A. Two or more qualified firms each saw tremendous value, growth, strategic fit and potential in this prize and did whatever they could to buy it as cheaply as the market would allow.

Here are a few examples of buyer negotiation approaches to help illustrate their every attempt to make an acquisition at the lowest price possible. Well, last year your sales were unusually high. I am just going to use the average of the last three years as my number. They recognize all of their software revenue when they make the sale. I am going to adjust my bid downward by the unearned income amount. I disagree with the amount you used for the owner's replacement salary in your EBITDA analysis. I am going to put in a fair market value number to come up with this reduced EBITDA number.

If the owner is trying to sell the business himself, he can usually only process one buyer at a time and thus these buyer negotiation tactics can be very effective. Likewise, if we only have one qualified buyer, it is very difficult to negotiate off these buyer positions.

However, in a professional M&A process, we design it to process several buyer pursuits in parallel. So when a buyer tells me they are going to just normalize the last 3 years' performance to lower their bid, I do not argue with them. My response is, you are certainly entitled to whatever methodology you want to employ to come up with your offer. Unfortunately your offer is no longer competitive with the marketplace. I will present this offer to my client, but I am pretty sure he will not counter sign your Letter of Intent. So in the example above, there were several very knowledgeable and talented representatives trying to buy as cheaply as possible and the market drove the valuation to a level that no valuation model in the world could have predicted.

A competitive M&A process will provide the ultimate company valuation. The decision now becomes, is it enough for me to sell?

 


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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

ACHIEVING STRATEGIC VALUE IN A SOFTWARE COMPANY SALE

One of the most challenging aspects of selling an information technology company is coming up with a business valuation. Sometimes the valuations provided by the market (translation – a completed transaction) defy all logic. In other industry segments there are some pretty handy rules of thumb for valuation metrics. In one industry it may be 1 X Revenue, in another it could be 7.5 X EBITDA.

Since it is critical to our business to help our information technology clients maximize their business selling price, I have given this considerable thought. Why are some of these software company valuations so high? It is because of the profitability leverage of technology. A simple example is what is Microsoft’s incremental cost to produce the next copy of Office Professional? It is probably $1.20 for three CD’s and 80 cents for packaging. Let’s say the license cost is $400. The gross margin is north of 99%. That does not happen in manufacturing or services or retail or most other industries.

One problem in selling a small technology company is that they do not have any of the brand name, distribution, or standards leverage that the big companies possess. So, on their own, they cannot create this profitability leverage. The acquiring company, however, does not want to compensate the small seller for the post acquisition results that are directly attributable to the buyer’s market presence. This is what we refer to as the valuation gap.

What we attempt to do is to help the buyer justify paying a much higher price than a pre-acquisition financial valuation of the target company. In other words, we want to get strategic value for our seller. Below are the factors that we use in our analysis:

1. Cost for the buyer to write the code internally – Many years ago, Barry Boehm, in his book, Software Engineering Economics, developed a constructive cost model for projecting the programming costs for writing computer code. He called it the COCOMO model. It was quite detailed and complex, but I have boiled it down and simplified it for our purposes. We have the advantage of estimating the “projects” retrospectively because we already know the number of lines of code comprising our client’s products. In general terms he projected that it takes 3.6 person months to write one thousand SLOC (source lines of code). So if you looked at a senior software engineer at a $70,000 fully loaded compensation package writing a program with 15,000 SLOC, your calculation is as follows – 15 X 3.6 = 54 person months X $5,800 per month = $313,200 divided by 15,000 = $20.88/SLOC.

Before you guys with 1,000,000 million lines of code get too excited about your $20.88 million business value, there are several caveats. Unfortunately the market does not care and will not pay for what it cost you to develop your product. Secondly, this information is designed to help us understand what it might cost the buyer to develop it internally so that he starts his own build versus buy analysis. Thirdly, we have to apply discounts to this analysis if the software is three generations old legacy code, for example. In that case, it is discounted by 90%. You are no longer a technology sale with high profitability leverage. They are essentially acquiring your customer base and the valuation will not be that exciting.

If, however, your application is a brand new application that has legs, start sizing your yacht. Examples of this might be a click fraud application, Pay Pal, or Internet Telephony. The second high value platform would be where your software technology “leap frogs” a popular legacy application. An example of this is when we sold a company that had completely rewritten their legacy distribution management platform for a new vertical market in Microsoft .Net. They leap frogged the dominant player in that space that was supporting multiple green screen solutions. Our client became a compelling strategic acquisition. Fast forward one year and I hear the acquirer is selling one of these $100,000 systems per week. Now that’s leverage!

2. Most acquirers could write the code themselves, but we suggest they analyze the cost of their time to market delay. Believe me, with first mover advantage from a competitor or, worse, customer defections, there is a very real cost of not having your product today. We were able to convince one buyer that they would be able to justify our seller’s entire purchase price based on the number of client defections their acquisition would prevent. As it turned out, the buyer had a huge install base and through multiple prior acquisitions was maintaining six disparate software platforms to deliver essentially the same functionality.

This was very expensive to maintain and they passed those costs on to their disgruntled install base. The buyer had been promising upgrades for a few years, but nothing was delivered. Customers were beginning to sign on with their major competitor. Our pitch to the buyer was to make this acquisition, demonstrate to your client base that you are really providing an upgrade path and give notice of support withdrawal for 4 or 5 of the other platforms. The acquisition was completed and, even though their customers that were contemplating leaving did not immediately upgrade, they did not defect either. Apparently the devil that you know is better than the devil you don’t in the world of information technology.

3. Another arrow in our valuation driving quiver for our sellers is we restate historical financials using the pricing power of the brand name acquirer. We had one client that was a small IT company that had developed a fine piece of software that compared favorably with a large, publicly traded company’s solution. Our product had the same functionality, ease of use, and open systems platform, but there was one very important difference. The end-user customer’s perception of risk was far greater with the little IT company that could be “out of business tomorrow.” We were literally able to double the financial performance of our client on paper and present a compelling argument to the big company buyer that those economics would be immediately available to him post acquisition. It certainly was not GAP Accounting, but it was effective as a tool to drive transaction value.

4. Financials are important so we have to acknowledge this aspect of buyer valuation as well. We generally like to build in a baseline value (before we start adding the strategic value components) of 2 X contractually recurring revenue during the current year. So, for example, if the company has monthly maintenance contracts of $100,000 times 12 months = $1.2 million X 2 = $2.4 million as a baseline company value component. Another component we add is for any contracts that extend beyond one year. We take an estimate of the gross margin produced in the firm contract years beyond year one and assign a 5 X multiple to that and discount it to present value.

Let’s use an example where they had 4 years remaining on a services contract and the last 3 years were $200,000 per year in revenue with approximately 50% gross margin. We would take the final three years of $100,000 annual gross margin and present value it at a 5% discount rate resulting in $265,616. This would be added to the earlier 2 X recurring year 1 revenue from above. Again, this financial analysis is to establish a baseline, before we pile on the strategic value components.

5. We try to assign values for miscellaneous assets that the seller is providing to the buyer. Don’t overlook the strategic value of Blue Chip Accounts. Those accounts become a platform for the buyer’s entire product suite being sold post acquisition into an “installed account.” It is far easier to sell add-on applications and products into an existing account than it is to open up that new account. These strategic accounts can have huge value to a buyer.

6. Finally, we use a customer acquisition cost model to drive value in the eyes of a potential buyer. Let's say that your sales person at 100% of Quota earns total salary and commissions of $125,000 and sells 5 net new accounts. That would mean that your base customer acquisition cost per account was $25,000.  Add a
   20% company overhead for the 85 accounts, for example, and the company value, using this methodology would be $2,550,000.

After reading this you may be saying to yourself, come on, this is a little far-fetched. These components do have real value, but that value is open to a broad interpretation by the marketplace. We are attempting to assign metrics to a very subjective set of components. This discipline allows us to help bring buyer and seller together in productive dialogue to bridge the valuation gap and create a winning transaction.

 


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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Business Buyers are Savvy Shoppers

The business sale process is a complex battle for leverage. A seller wants to invite many qualified buyers to the table and position his company to produce strategic value. The experienced professional business buyer has his own arsenal of tools to move the balance of power in his favor. This article examines how Private Equity Groups approach the process and try to stack the odds in their favor.

We preach to our business seller clients the benefits of testing the markets and inviting many qualified buyers to participate in the process. The ultimate goal is to get two or more buyers that recognize the tremendous synergies that the combined companies could realize and produce offers that are not based on a financial multiple, but on a strategic value premium. A financial multiple would be a purchase value something like 4 X EBITDA (basically cash flow) or 70% of annual revenue. 

What would produce strategic value? The good news is that this can be created in a number of different ways.  The evil "Wall Street stereotype" is to eliminate duplicate functions and save a tremendous amount in payroll expenses. I am not a big fan of this as the reason for doing an M&A deal. Somehow tearing something apart does not represent any particular management imagination or skill. Identifying ways to build value by creating the sum of the parts that far exceeds the inputs is real visionary management. 

This strategic value can be created by acquiring a complementary product line that can be added to a strong sales and distribution network.  Acquisition targets can provide superior systems, business models, product technology, and  management talent that can be leveraged by the new combined company to produce revenues and profits that far exceed the two separate companies. 

This sounds easy on paper and makes a lot of sense, but the truth is that most acquisitions fall short of expectations because, integrating all the systems, personnel, culture, locations, customers, etc. is complex. This makes buyers cautious. When buyers get cautious, they revert back to the conservative financial multiple which basically provides a safety net to their investment if the post acquisition synergies are not realized.

We subscribe to a private equity group database which helps us identify likely buyers of our sellers based on searching their investing criteria and identifying their portfolio companies. A surprising discovery I made is that in this particular universe of the largest 3500 private equity groups, they owned a combined 46,000 companies. If you wanted to draw any conclusions about business buyer behavior, this would be your group of target subjects.

First conclusion is these guys want to win. Sure it's money, but it is the game and the competition and thrill of the conquest that also drives these serial business acquirers. They think they are the smartest guys in the room (hey check their educational, and job history background) and on paper  they may just be. But you only need to have one failed $20 million acquisition to instill some real rigor and financial conservatism into your process.  They want to stack the deck to put as much as they can in their favor to make these investments winners.

The first thing they do is look for Warren Buffet type businesses. You know the ones that have a durable competitive advantage, positive cash flow, steady growth rate, loyal customers…… They want to draft Payton Manning coming out of Tennessee - Great start.

The next tenant of their success formula is to take advantage of the large company valuation premium. This is how it works. Their first acquisition into a market space is generally a bigger company, say $25 million in revenue. Let's say that this valve and pump company sells for a 6.1 X EBITDA multiple. They then attempt to make a series of tuck-in acquisitions of a $5 million valve company here and a $4 million pump company there. These smaller companies command a smaller valuation multiple than the large company, say 4 X EBITDA. The day the acquisition is completed, the PEG has already won because the acquired company is now valued at the higher EBITDA multiple of its new parent. They make a series of these investments, grow the company organically as well for 7 years and then sell their $150 million in revenue company to a strategic buyer at an EBITDA multiple of 7.8 X.

These sophisticated buyers are very disciplined in their acquisition process and very seldom stray from the strict EBITDA multiple offer.  In order to stick to that discipline, they have to look at a lot of deals. We normally ask our buyers that have signed NDA's and looked at our client, and then withdrew, why they dropped out. We get a lot of different answers, but the top answer is that they were in another deal and would not be able to process both at the same time. Most of these firms invite 50 - 100 potential acquisitions into the top of the funnel for each one that they complete.

So, what they are doing is creating the counterbalance of the leverage we are trying to create by getting lots of potential buyers involved.  They have multiple options, so if the price gets too high, they go for easier prey. If the sellers are difficult, they move on. If the financial reporting is shaky and unclear they find a company where it is transparent.

Please don't let me give you the impression that this process is totally by the numbers. There are great companies that will command a premium, but just like buying a luxury automobile, they are still shopping.

 


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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Valuing The Growth Rate in the Sale of a Technology Company

If you are selling a rapidly growing business, especially one based on technology, using an EBITDA multiple will not provide an accurate valuation metric. This article presents an argument that these businesses should more appropriately be measured like the concept of Price to Earnings to Growth (PEG) Ratio that is used for rapidly growing public companies.

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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Valuing The Growth Rate in the Sale of a Technology Company

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