Savvy venture capitalists and private equity firms strive to acquire thriving companies at the lowest prices they can achieve. In defense of their stake in the company, sellers need to be proficient at using the available valuation options for rapidly increasing future revenues.
The Price Earnings Growth (“PEG”) multiple is widely used as a factor in determining startup valuation. But this factor is generally only used for companies valued for acquisition by a publicly traded company. With respect to transactions involving private companies on both sides of the table, there is no corresponding valuation metric, so PE and VC firms routinely come in making offers with multiples of seven, eight or more than ten times EBITDA for a company that has only experienced a few short years of positive cash flow. Compared to companies with a long track record of earnings, these offers become flattering and enticing. But should they be?
How Buyers Work to Manage Acquisition Price
Remember, “experienced business buyers are masters of setting the rules for how they calculate the value of a business they are attempting to acquire.” Dave Kauppi | April 6, 2016 Source: Stnazkul – Dreamstime.com.
The use of standard multiples (3x or 5x depending on the industry), fails on many levels. The easiest of those to see is in the situation of rapidly fluctuating EBITDA. If it would take a higher salary to replace the current owner than what he is making on the date of sale, buyers often push for a lower valuation based o the costs it will incur. Business rents are still another expense the buyer will try to use to reduce the valuation of what it should pay.
Valuing Growing Revenue Streams
In private acquisitions, there is generally no allowance for revenue, let alone earnings growth. While a public company is forced, via accounting rules that are weighted against the public company, to take this valuation into account, historically private companies have pretended as if such a valuation mechanism really makes no sense for a company with less than $5MM of EBITDA.
But then, I ask, really? How can it be that the company that has passed beyond the highest slope along the growth curve gets treated as if it’s a startup because it’s being acquired by a public company, while the company that is just turning the corner on the hockey stick of growth is treated like it’s a mature company with no expectation of strong future growth. Frankly, these practices are inane.
In David Kauppi’s work for Divestopedia, he developed a hybrid for overlaying the valuations that are achieved when appropriate PEG models are employed against the traditional EBITDA multiples used by private companies. He starts by calculating the PEG for some of the largest and most well known companies in the US, for example, Google, which in 2016 had a PEG of 1.98, based on a PE of 33.37 and earnings growth 16.85.
Google sells at a PE multiple of 33.37. The PEG of Google in 2016, which equals the PE multiple divided by the five-year growth rate, was 33.37/16.85 or a PEG of 1.98.
That’s a good frame of reference. If Google’s PEG is 1.98, no one will want to pay a higher PEG, unless the company is a true superstar of the future (we’ll discuss that possibility later).
Devising an Adjustment Factor
Kauppi cited an anticipated five year growth rate of earnings in the S&P 500 the anticipated five-year compound growth rate of the S&P 500 as of 2016 of 1.16, compared to 2.178 (1.1685 compounded for five years) for Google, making it 1.878 times greater than the broader market. If the market PE was 17, it was between 15 and 16 in 2016, multiplied by Google’s adjustment factor of 1.878 brings you almost exactly to its own PE ratio of 33. What this shows, then, is that the market absorbs potential future earnings into the stock price across the S&P 500.
Still, it’s a much harder calculation, based on a much less predictable forecast, when you’re talking about a startup company. Thus, our ultimate conclusion, when paired with a bit deeper analysis, is that PEG alone doesn’t go far enough in valuing an early stage company. You ultimately have to be able to look at: 1) the most predictable trajectory – revenues, and 2) – allow for a significant standard deviation from predicted earnings growth. While there is always some deviation between projections and actual performance, because the earnings side of that equation will often be less predictable than the easier projection of revenue growth, it may be imperative to use revenues to create the essential adjustment factor away from traditional EBITDA valuations. Like all other valuation techniques, this choice can cut either direction in the ultimate pricing for the company, depending on how the information is deployed.
The Buyer’s Perspective
Buyers of micro-market, and lower middle market companies generally prefer to defer to one of two methods of valuation: 1) traditional EBITDA methods, or 2) discounted future cash flows. The latter is much better suited for a tech startup in general, and that is essentially the argument laid out above. The problem for the buyer is that the current trajectory of revenues and projected revenues can take an otherwise appetizing deal, and make it completely infeasible. Buyers have certainly become more aggressive in 2017 and 2018 in moving away from EBITDA multiples and looking at some extraordinary cash flow projections, but the market will always dictate that they return to models that successfully predict winners, and EBITDA is thought to have a much better track record on this score.
Sometimes a two part deal structure, initially based on EBITDA, and then adding a kicker for high performance later, works around the challenges the two sides face in coming to terms on a transaction from the outset.
If your EBITDA is $1 million and the industry standard is 5X EBITDA, for acquisition, you can get $5,000,000 at the closing table. But due to projected growth of over 20% per year, you believe the company should bring a multiple of 8X EBITDA, or $8,000,000. In its cash flows analysis, the Buyer has actually already considered that the company could be worth as much as $12,000,000, but hasn’t disclosed its private calculations to you.
So you negotiate for a $3 Million kicker in three years as an achievement based earn out, which the Buyer allows as an earn out that can go up to $7 Million in five years if you hit their own revenue targets. You walk away from the closing table with less than your original hopes, but come away with a deal that means you don’t have to look for new, rapid growth opportunities elsewhere, all you have to do is armchair quarterback your own deal to the growth projections you were hoping for, with the capital in hand to get there.
The successful buyer can only remain a successful buyer if it does not overpay for deals it absorbs. Every failure is costly, even if that failure is measured on falling short of earnings projections. The buyer needs the seller to think along with them in targeting future valuation. The less money they have to put on the table at closing, the more the deal is driven by what actually happens in the future. But the zero sum game of exchanging money at closing means the seller is taking less upfront. To protect themselves, sellers need to be sure they cover a minimum “walk away” valuation now, and seek the benefits of wisely projecting, and participating in the growth of the company in the future.