Wonder how to value a going business? Find out how successful investors do it. (For companies too young to generate much revenue, see HOW TO VALUE A START-UP.)
Read the Start-up article anyway to learn how to use projected cash flows to value a business. That’s something all valuation technique do even if there are variations that depend on the company’s lifecycle stage and industry. The article also describes non-financial signals that investors believe add value to any company at any stage.
Lifecycle Stage Drives Valuation Technique
Companies pass through four lifecycle stages – Start-up, Growth, Maturity and Decline. In the chart below,
we link these stages to the types of techniques that investors use to value them. In general:
- The older a business is;
- The more quantified financial data it has;
- The more predictive of future cash flows that data is, and therefore;
- The more investors use that data to estimate value.
Our chart also links the four lifecycle stages to the level of risk and the type of investor comfortable with that level of risk.
Why include investors in an article about valuation? Because — for example — if you’re interested in very rapid growth, you need to know both what type of investor to court and how they’ll value your business. That way you can work on creating signals associated with value before you solicit them. (As for rapid growth, aka “scaling,” see our article HOW TO GET BIG FAST.)
But keep in mind that the labels we use in this chart – stage, investor type, valuation technique — are rough generalizations. There are no sharp lines, only gradations.
Overview of Valuing Growing and Mature Companies
As mentioned, with passing time a company’s financial signals gradually accrete and take center stage in estimating value. That’s stuff like amount of revenue, how much of it is recurring and how fast that’s growing, cost of customer acquisition, gross margin amount and trend, EBITDA, free cash flow itself, etc.
So while some non-financial signals like proxies for sales (e.g., eyeballs) or strong buyer interest in a prototype might predict future cash flows, certain financial metrics actually do.
Crunching Numbers
Buyers who value companies in the Growth stage – as well as companies in Maturity and sometimes Decline stages — use a suite of impressively detailed and complex quantitative techniques to predict NPV for three reasons:
- They’ve got lots of numbers to feed their sophisticated models;
- They can apply advanced statistical tools to those numbers like Monte Carlos simulations of future cash flows. Or regression equations and AI to identify what the drivers of value are among companies like the one they’re examining.
- Since the companies being valued tend to be larger, investors figure the cost to develop very high valuation precision is worthwhile.
For a list of projects that grow financial metrics and thereby value see HOW TO INCREASE YOUR COMPANY’S VALUE: A RENOVATION CHECKLIST.
When Things Get Simpler
Sadly, mature companies don’t just keep getting more valuable. Those still standing as independent entities eventually enter the Decline stage where they either exit via M&A, or if they’re no longer a “going concern,” sell for parts.
Note how powerful a force Darwinian selection of the fittest companies is: in 2020 only 10% of the businesses on the 1955 Fortune 500 list were still standing. Those companies that find themselves in end-stage Decline call for yet another type of valuation technique, that associated with various types of liquidation including asset auctions, mass hires, etc.
VCs: Sales Growth Sherpas
VCs fund the transition from companies from no or little revenue to material, reliable revenue. That’s from the Start-up stage through the Growth stage. Almost all the money they spend goes directly into the target company to jack growth. This focus on revenue is a clue to the valuation techniques VCs favor.
For instance, many use multiples of sales with the multiplier differing by industry. For a long list of such revenue multiples by industry see a chart by Eqvista. Valuators generate these multiples by reviewing the histories of similar companies. Looking to the behavior of similar companies is called a “comparables” analyses.
ABC: Always Be Closing
Why use a multiple of sales? Rather than relying on a very young company’s historical cash flow – which VCs assume is nearly irrelevant (costs are heightened by one-time expenditures, meagre scale, low learning efficiencies, and no brand recognition) — VCs forecast what these costs could eventually be. They do that by looking at the financials of established companies in similar businesses.
Still, VC funding remains quite risky. Estimates of funded companies that fail to generate any ROI at all range up to three-quarters.
But There’s Still Time for Touchy-Feely
So, in addition to forecasting sales, most VCs also look even closer than angels on certain non-financial signals like:
- Management quality (which they consider the single most important factor);
- The degree to which they can add value to the company based their own industry experience and connections;
- Pricing competition from other VCs and;
- The scale of the opportunity.
In this case, “scale of opportunity” means not only the size of the addressable market but also the plentitude of exit opportunities either by M&A or IPO.
For further interesting insights into what VCs consider when making early-stage investments, see How Venture Capitalists Make Decisions published in Harvard Business Review.
PE Players: Financial Engineers
A Quick History
Back in the day, most private equity firms were staffed nearly entirely by financial engineers. They were then mostly known as hedge funds. After using analytic skills to identify cash-heavy companies with underused debt capacity,
they bought out the shareholders and if they could, later distributed to themselves rich dividends. Where did the money come from? A slice from them but mostly from banks that lent to the company itself.
PE general partners thought, if a company’s management can’t find a use for their idle money capacity, the PE firm would. Thus, the era of LBOs.
The Beginnings of PE Value-Add
Today’s PE firms add more value than exploiting a company’s debt capacity then cuttings costs to pay it down, though their financial modeling expertise and search for cheap debt still drive the business.
And unlike VCs they still spend as little as possible on the target itself — their money mostly goes into buying equity from the prior owners like VCs and more rarely, bootstrapped entrepreneurs.
What’s different is how much effort they now put into finding ways to make the target’s subsequent growth self-funded.
They began doing this in the mid-eighties by buying “platform” companies that they then integrated with “add-on” acquisitions for economies of scale. As consolidation continues, this game has moved into ever more specialized niches. The exception is a few industries like software that keep generating as many targets as the PE consolidators can buy.
Another source of PE investment is new, emerging industries like SaaS and cryptocurrency used to be, and now AI is.
As an example, as soon as an AI player displays solid financial signals that predict reliable and growing cash flow, it attracts PE attention — like any other industry behaving that way. (Exception: heavily regulated industries like commercial banks and utilities.)
So How Do PE Firms Quantify Value Now?
They look for ways to enhance operations: cut target company costs, increase sales, then find buyers to take them out at a value that meets their NPV or more.
In detail, they:
- As later-stage VCs do, create detailed models to predict cash flows for the current business as well as for the business after they model certain changes.
- Changes like how much of their cash offer they can pay with the target’s debt while not threatening the golden goose itself. (They can miscalculate but these days rarely do — it’s bad PR.)
- And at the same time, looking at where they can cut costs post-close;
- Sometimes make limited investments to enhance operating efficiencies and effectiveness;
- Scan for acquisition targets in neighboring industries and geographies to confirm opportunities for economies of scale;
- Last, identify potential future buyers, either big strategics (operating companies), or other PE firms that are investing with younger funds (every fund has a lifespan of about five years). Sometimes a PE firm will exit via IPO.
After they’ve checked all these boxes, they’ve got an NPV in mind. Naturally it’s higher than the offer they make to the target. For a more detailed description of the valuation process that most PE firms use to make offers (but not how they forecast post-close changes), see Hadley Capital’s calculation.
At the end of the day, like all other valuation attempts solidly based in NPV theory, PE firms first forecast time- and risk-adjusted stand-alone cash flow, tinker with ways to enhance it under their ownership, then add an exit multiple.
But don’t forget that this approach doesn’t compel the acquiring PE firm to share with the seller any of the value that it brings to the table through actions like those listed above. That value is one of the reasons that sellers hire an investment banker to figure out and negotiate.
Values in Decline
This Decline stage, one where there’s little or no “going business” value, is often a dreary place characterized by “fire sale” auctions of assets for as little as 5% of depreciated value. For distinctions among the types of assets sold under one or the other types of bankruptcy, see Investopedia’s entry.
But occasionally opportunists liven things up – be they strategics, PE firms or hedge funds – when they see “grave dancing” opportunities and pay higher than dead asset value. Those plays frequently occur with real estate assets (e.g., how Sam Zell made millions) and with intangible assets like brand names.
Examples: entrepreneurs plucked the Brooks Brothers, Pier 1, The Sharper Image and Lilly Pulitzer labels out of bankruptcy and they live on today under the ownership of otherwise unrelated PE groups, manufacturers and distributers.
In sum
How VCs Play
VCs heavily weight revenue and its growth when defining value. Nearly all the money they spend to buy equity goes directly into the target company to accelerate sales. After doing so and before growth slows, they usually sell out to strategics or PE groups. Sometimes, with explosively growing tech companies, they IPO.
How PE Groups Play
In contrast, PE groups first heavily weight opportunities to enhance current cash flow by adding debt and cutting costs. Nearly all the money they spend goes to buying out the target company’s owners.
After increasing efficiency through means easily found at hand within the target company itself, the PE firm ranges abroad to find economies of scale and sales growth through M&A.
Having created a bigger more profitable company, they then sell to a strategic, the public, or to another PE group that invests using a younger fund. If that happens, the cycle starts all over again.
