Open up any corporate finance textbook and you’ll find thousands of pages devoted to valuation theory, valuation principles, and techniques for arriving at a rational and dispassionate value for your company.
No matter how sound the valuation theories are, companies are valued in the real world, by real people with varied motives, amidst a dynamic market and uncertain future that no one can perfectly predict. And so entrepreneurs must focus on driving their company’s valuation by building the best business they can build, engaging with real-world investors and potential buyers, and painting a picture of their company’s future that is both expansive and credible.
Supply and demand factors are key to how high valuations are going to be. “What it comes down to, more than anything, is supply and demand of capital in the market versus those companies that are available to invest in,” DelMorgan & Co.'s Managing Director, Matt Slonaker, says. Recently, the large amount of cash reserves on corporate balance sheets both domestically and internationally as well as the historically high private equity overhang are driving up valuations. “There’s just a tremendous amount of money available in the marketplace and banks are also extremely aggressive right now in deploying money,” says Slonaker.
By the time you’ve decided to actively sell your business or raise a round of financing, you’ve got to put building the business on hold and devote your attention fully to the capital raising process. At this point in time, the two most important drivers of your company’s valuation will be:
ɚ Its future
ɚ Competition among investors
Let’s address these one by one.
THE FUTURE
Investors only care about the future of your company. When an investor studies your company’s historical track record, reviews your financials, or interviews your customers, they are doing it to look for clues about the future prospects of your company. The quality and credibility of the picture you paint of your company’s future — the size of your market opportunity, the speed and predictability with which you can serve your customer base, and the defensibility of your product offering — is the most important driver of your company’s value.
In an uncertain world, the more predictable and sustainable your company’s future profits are, the more valuable it becomes to investors, who constantly assess the risks and rewards of an investment opportunity.
Many entrepreneurs get mired in the details of valuation or put their head in the sand and simply pick a number based on their personal needs or what they heard was “right for their industry.” This is wasted time.
COMPETITION AMONG BUYERS
A credible and compelling future makes it easier to attract investors. And if you’re raising money or selling your company, competition is a must-have. You will not dependably realize a fair value (let alone maximize your offer) for your business without multiple uniquely interested and credible parties at the table. It doesn’t matter if your business has been growing at 100% top-line with 50% EBIT margins for 10 years straight — if you only have one interested party at the table, you have created no competition for your business and will struggle to achieve a fair outcome. For entrepreneurs more familiar with selling to customers than with raising capital or selling their company, think about your sales process: the richer your pipeline of customer prospects is, the more choosy you can be about which prospects you focus on closing, and the more disciplined you can be in negotiating the pricing and terms of the customer contract. The exact same concept applies to raising money or selling your company.
Creating competition in a financing or exit process is one of the most important reasons the investment banking profession exists — similar to a good real estate agent, a great investment banker helps business owners drive to a fair outcome by attract multiple, interested parties that are acutely and uniquely motivated to buy or finance your business.
As you prepare to raise money or sell your company, ignore all of the noisy free advice you’ll get and focus on two things: how to crisply and credibly articulate the future of your business in the most predictable and expansive way possible, and devoting meaningful time to doing the necessary networking and relationship development (meeting with investors before you formally initiate a process, meeting investment bankers who can help you) in advance so you can attract a set of uniquely and acutely interested partners to the table.
Discounted Cash Flow (DCF) Valuation Model
There are several ways to value a business. By far the most popular is the discounted cash flow (DCF) methodology. The DCF is grounded in a simple concept: that the value of any given company is equal to the sum of all the future cash flows of that company, discounted to reflect their value today. Should you want to sell, or conversely, buy, a business, this is the price that you would ask for in order to break even.
The DCF model is grounded in a simple concept: the value of any given business is equal to the sum of all future cash flows of that business, discounted to reflect their value today.
This raises the question of where the formula’s inputs came from. Here’s where the DCF business valuation technique breaks down. A discounted cash flow valuation is only as good as the assumptions that create the valuation’s inputs. In the above example, we made assumptions about discount rate, cash flows, lifespan, and growth rate. If any of these prove off-target, the end result can be misleading. As the saying goes: garbage in, garbage out.
Below we look at how to make better assumptions for valuing private companies. We’ll also look at the limitations that come with DCF valuations.
CASH FLOW ESTIMATION
You’ll find it hard to know where you’re going if you don’t know where you’re coming from. Unfortunately, the history of a private company is almost always more obscure than that of a publicly traded company. There are a few reasons for this. Often:
ɚ Private firms are younger than their public counterparts. There is less of a track record you can use to build your pro formas.
ɚ Private firms don’t face the same accounting and information sharing requirements from regulatory agencies and exchanges as public firms.
ɚ Private firms’ financials might not account for the true cost of running the business.
These points all underscore the added care one must take with a private company DCF valuation. With young companies, an investor must realize his cash flow predictions will rely more heavily on assumption and less on history. When examining the financials, he will have to be careful to make sure the accounting is acceptable for the purposes of the analysis.
And the unique factors of a small private company must be included in the estimations. What if the founder will leave after the sale? Does her current salary reflect the true cost of replacing her?
DISCOUNT RATE ESTIMATION
The discount rate is the rate of return the investor requires from this investment. If he perceives the investment relatively risky, he will require a higher discount rate.
When valuing public companies it’s assumed the investor is properly diversified. This eliminates some of the risk of the investment. With a private company no such assumption can be made. For example, the investor might be a private equity fund specializing in a specific sector and making an investment in that sector.
Discount rates should also typically be higher for a private firm than a public firm because of a difference in expected longevity. With public companies, there’s an assumption that the business will continue indefinitely. Smaller private companies with a key founder involved in operations have a shorter expected lifespan.
CONTROL PREMIUM AND ILLIQUIDITY DISCOUNT
There are a couple other key items that should be taken into account for a DCF valuation of a private firm. One increases its value, the other decreases it.
The premium derives from control and the value that control can realize. Unlike most purchases of shares in publicly traded firms, the purchase of a private company often comes with a great deal of control over the company. If the business is poorly run and the investor believes he can improve financial performance by exercising their power to change management, there will be a significant control premium.
The transaction costs to buy and sell shares in a public firm are virtually nil; the resources and time required to buy and sell a private company are significant. The DCF valuation should account for these costs. This illiquidity discount is widely attributed for the 20 to 30% price discount sales of private companies exhibit relative to sales of public companies with comparable financial performance.
LIMITATIONS OF DCF VALUATIONS
DCF valuations can be a powerful tool if used properly but also have serious limitations. We discussed above the difficulty of properly estimating cash flows from a private company. Estimating a trustworthy discount rate is not an easy matter either.
These issues are compounded because tiny changes to the inputs of a DCF valuation can have big effects. Discounted cash flow models often assume a business will operate for a long or infinite period of time. A tiny change in the growth rates of cash flows or discount rate can cause a huge swing in value.
Let’s go back to our example. Say the sinkhole next to the widget factory stops expanding. We now assume the factory can operate as a going concern forever with a constant growth rate. In this case, we would use an infinite period constant growth rate DCF model.
If we expect growth of 3% and use a discount rate of 6% we get a value of $34,333. If we expect growth of 4% and use a discount rate of 5% we get a value of $103,000. Some small changes in our growth and discount rates estimates cause the DCF value to triple.
Look for our fourth part of the nine part series later this week. In part four, we will discuss the marketing presentation for your company.
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