How to drive up your business valuation for a profitable business exit

 A business is worth only what a buyer is willing to pay for it, or so the adage goes. Theoretical valuations, however, play an important role in providing a defensible starting-point for negotiations and can position your business to attract the most suitable potential buyers.

Fortunately, business valuations are not immovable objects. But what factors drive company valuations, and what steps can you take now to maximise your business’s value before bringing it to market?

Determinants of your valuation multiple

The most commonly accepted methodology to derive the value of a business is by calculating a multiple of earnings, such as EBITDA. A multiple is inversely related to Return on Investment (ROI) or capitalisation (cap) rate. For instance, a 5.0 multiple equates to a 20% ROI or cap rate, whereas a 4.0 multiple corresponds to a 25% ROI or cap rate (1/4 = 25%).

Business valuation typically employs a range concept due to the broader spectrum of possible values compared to other investments. For example, a business might be valued within a 4.0 to 6.0 multiple range. However, where in this range your company’s falls will depend on its value drivers which generally fall within one of two categories – growth and resilience.

Key value drivers

Your company’s valuation multiple is not static. Addressing the areas in your business model that could drive growth and resilience could help to drive up your multiple.

Growth of earnings

Growth potential significantly influences valuation multiples, especially when targeting private equity (PE) buyers. As a rule of thumb, PE firms seek investments capable of doubling earnings within a four-year timeframe.

In this respect, demonstrating historic growth and future scalability is important: are you currently only serving a small share of the total addressable market? Do you use software or technologies that can easily be scaled without significant capital expenditure? By effectively communicating growth potential, you can justify a higher valuation to potential buyers. 

A high free cash flow (FCF) conversion ratio would also be a value driver, because it tells the buyer how the business’ profits convert into cash. Calculating the FCF conversion ratio comprises dividing free cash flow (FCF) by a measure of operating profitability, most often EBITDA. These metrics are especially important during tightened economic conditions.

Resilience

Resilience is an important factor in determining the appropriate valuation multiple. This includes factors like quality of earnings and customer stickiness: are the company’s revenues recurring or based on ad-hoc orders, and what is your customer churn rate?

It will also include factors like barriers to entry. How difficult would it be for another business to replicate your services? Does your company own the IP to the products it sells?

The human-factor is also important, especially for service-based businesses where your staff are a sine qua non. For example, what is the likelihood of key personnel exiting the business? And how reliant is the business on you, the shareholder?

“The value of a firm is a function of three variables—its capacity to generate cash flows, its expected growth in these cash flows, and the uncertainty associated with these cash flows.”

Aswath Damodaran, ‘The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit’

Maximising your earnings measure

Now you’ve got your multiple, you’ll need to look at maximising the ‘earnings’ side of the equation.

The metric used is usually EBITDA, however revenue multiples are often used for tech businesses due to their low “cost to serve”. Ultimately, it is intended to serve as a proxy for the level of sustainable cash that can be generated from your profits.

The goal is to present a “sustainable” earnings figure that accurately represents the business’s profit-generating capacity. This figure should be realistic rather than overly optimistic so that it withstands scrutiny during due diligence.

A sustainable earnings figure is usually arrived at by making one-off adjustments (removing unusual, non-recurring items) or making run-rate adjustments by annualising recent performance to reflect your business’ momentum.

In some cases, pro-forma adjustments can be made which show the full-year impact of recent or imminent changes, such as new client contracts.

In the Information Memorandum or other sales collateral, you may also wish to quantify buyer-specific synergies, such as cost-saving synergies achieved through consolidation of supply chains, technology, staff and more, as well as revenue synergies achieved through cross-selling.

What now?

Engaging an experienced and knowledgeable adviser like Hilton Smythe early in the process is key.

They can provide invaluable assistance in identifying your key performance indicators (KPIs), recognising your business’s value drivers, and pinpointing potential value drags.

They can also assist in the valuation process. With access to large volumes of historic and recent transaction data, a business valuation professional will look at the entire picture, factoring in the business model, stage of growth, the quality of management, low/high CAPEX, industry-specific dynamics and more, to arrive at a nuanced valuation that reflects the company’s potential.

They will also be able to advise on what adjustments need to be made to your EBITDA to reflect a realistic and sustainable earnings figure.

They will also be able to guide you through the sales process, ensuring you approach the right prospective buyers at the optimal time. With their help, you can craft tailored messaging that resonates with potential buyers, create competitive tension, and ultimately maximise your business’s value.