What's It Worth To You — Valuing Businesses

One of the more engaging topics I am involved in about my profession is around the question of how to value businesses. Valuation is the most interesting part of my line of work — maybe because I am a finance nut at heart. Some buyers hate valuations. Certain entrepreneurs want to acquire whatever they can as fast as they can. This strategy gives them relevancy in their industry and squeezes out competition. The early successes of this venture usually result in mountains of debt and a messy group of individual assets that need to be integrated together. My focus has always been to complete smart acquisitions by soundly valuing businesses.

The decision for a business owner to acquire is no different than other choices they make about spending their money. The first step in creating a valuation is understanding the buyer's own business. They need knowledge of how much it costs for them to borrow money. WACC (weighted average cost of capital) is an average cost of all the debt on a business. Almost all growing businesses have debt for equipment, working capital, etc. This WACC should also be the minimum return they get for investing in the base business. If it's costing you more to borrow the money than the return you are getting from it, it is a wise move not to borrow that money. Making sure you understand your company's WACC — and whether your acquisition can repay the debt you borrow — is the first step in a successful valuation.

Buying a business to add on to your growing organization is simply a financial calculation. You can spend your capital within your business by adding salespeople, replacing equipment, or upgrading your systems. Conversely, you can spend it by growing through acquisition. WACC is the return you get on spending your capital on internal growth. So the second step in valuation is to understand the return you get on acquiring someone else's business. The most recognizable calculation to determine this is IRR (internal rate of return). IRR measures cash flows over time and provides a percentage to measure against your cost of capital. To do this, you will need to input the following variables:

Purchase price

This is the capital that is outlaid at time zero of the model. Additional costs to close an acquisition (legal, diligence) can also be included in this number to increase the accuracy of your model.

Annual cash flow

Most valuation models run between three and ten years — the most common is five years. During those years you need to estimate how much cash is being generated or lost. This may seem like a daunting task, but skillful forecasting is key to answering the question of whether you buy that business or not. Start with historical financials to understand how the business has been performing and its trajectory. If you are in an industry with longer-term customer contracts, review those to see how long your revenue will be guaranteed before negotiating renewals. Review the assets of the seller's business as well. Will you need to replace anything in the coming years that will be a capital outlay for you? Compare the costs in their business to yours — can you operate more efficiently and save money once you combine the businesses, or will you need to spend more to operate their business more safely and within regulations? These synergies may accumulate over time or come all at once, and can be inserted into the cash flow of the model.

Exit price

At the end of the model, you have a marketable business to sell. Even if you do not plan to sell the business at the end of your valuation model, it is still worth something — hopefully more than you paid for it. Larger companies use the exit price to create the most value in an acquisition. The rationale for acquiring smaller companies is that they become more valuable by being part of a larger entity. In the industries I have been involved in, smaller companies sell for approximately 3–6 times their annual EBITDA, while larger companies sell for approximately 8–12 times their annual EBITDA. This is because larger entities have more growth potential and a stronger base of operations — more sophisticated systems, call centers, bigger geographic scope, or more lines of business. Anyone who knows cars realizes it's easier to increase the speed of a car with a bigger engine than one with a smaller engine.

A quick example below shows a business that was generating $20K annually in EBITDA. In this case, I assume the business will continue to generate the same cash each year after the acquisition. The business is acquired for 5 times EBITDA ($100,000) and exits at 8 times EBITDA ($160,000).

This example generates an IRR of 27%. That IRR is compared to the buying company's WACC to help decide whether to use $100K of capital for this acquisition or put the money to work elsewhere. Good buyers use a number higher than the WACC to compare against the model IRR — acquisitions are inherently risky, so adding 4% to 8% as a "risk premium" on top of the WACC is prudent.

Is it this simple? At a base level, yes. But several factors can change the numbers. Will this business generate the same profit being part of the acquiring company as it did on its own? Are the customers and employees going to be satisfied with the buyer? Can the buyer get the increased multiple on the exit price? Great modeling is achieved when you create several scenarios and adjust these factors to see how they affect your returns.

Your model is complete, and you are comfortable with your valuation — did we forget something? The seller needs to agree with your valuation. Sellers have different motivations for selling their businesses. Some make financial decisions much like the ones we've talked about: did they get a good return on their past capital spend? Do they think they cannot create additional value without investing more money and time? Do they have financial trouble and need to pay off debt? They also could have personal motivations — retirement, family emergencies, and so on — that all play a part in how much a seller is willing to accept in value.

The final piece of the puzzle is the market price — the estimate of what the market thinks businesses in this sector are worth. In most cases, markets talk in multiples of EBITDA. Why is this relevant? For buyers, comparing a valuation to the market tells them whether they're overpaying for an asset. If market rates are 4–6 times EBITDA, why would you pay 8 times EBITDA for a certain business? The market is telling you there are other businesses you could buy for cheaper. There might be a reason to buy at a premium — in similar ways, you might pay over market for a house in the perfect neighborhood or school district — but being deliberate about that strategic decision is what matters. Likewise, a seller should be skeptical about selling for lower than market, knowing other businesses are being sold at a higher price.

Buyer valuations, seller expectations, and market prices all must align to complete an acquisition. Why have so many acquisitions closed in the past decade, and why do I keep hearing that acquisitions are stalling out? The answer is in the first item we spoke about: credit. Low interest rates mean your average cost of capital will be lower. Lower cost of capital means you can pay more in a valuation and still make a good return — and it means a seller could invest more in their business before selling it, increasing the value. Not only low cost of capital, but more critically, stable cost of capital lets buyers forecast their costs and be confident in the money they're investing. When interest rates are rising, the toughest part for buyers isn't the higher rates — it's not knowing how much higher they will go. Once rates settle, expect buyers to value more companies and complete more acquisitions, and expect sellers to see a lower bid price due to higher costs of capital. Some sellers will have missed an opportunity to cash out of their businesses at higher valuations. They'll come to terms with that, and the system will reset at these new levels. The rebalance will be complete — and like every other system on this wonderful planet, life, death, and rebirth will happen in mergers and acquisitions.