Explained: How will an investor value your company?

Imagine you’re scrolling through real estate listings, and you come across an interesting-looking property. The pictures may look great, but how do you determine if it’s a sound investment? Odds are, you’ll need to do a bit of research before you can feel confident that it is the right purchase for you and the price you’re offering is a fair one.

This process of evaluation is not too dissimilar from the process investors undertake when seeking to invest in businesses. And before any deal can be struck, both investors and business owners must agree on one very important detail…the valuation.

There are potential upsides and downsides to every investment opportunity, which can sometimes make it tricky for both business owners and investors to agree on a specific valuation. However, understanding more about how investors will evaluate your business can help you prepare for these discussions and secure the best possible deal.

Let's examine the fundamentals of valuations

Setting a common financial metric to value a business enables investors to make comparisons between different businesses and industries. Determining the financial value of a publicly traded business is relatively straightforward; the equity value is calculated using the share price times the number of shares. The trades of thousands of people each day set a public consensus of share value, or a ‘market price’.

Valuing private businesses, however, requires a different approach and a common language between the owner and the investor needs to be found for discussing the valuation.

One methodology that serves as a useful (and common) starting point when valuing a private business is the EBITDA (earnings before interest, taxes, depreciation and amortisation) multiple approach. EBITDA provides a snapshot of the business’s operational performance. For businesses with low capital expenditure, this is a good proxy for the cashflow that would be produced by the business and distributable to its owners before any debt servicing requirements.

The EBITDA multiple is a number applied to a company’s EBITDA to produce the Enterprise Value. The Enterprise Value represents the total value of a business (much like the price of a house) and is the sum of the equity value (value attributable to shareholders, or the homeowners) and the net debt (total debt minus cash, or in the case of the house analogy, the value of the mortgage minus any cash sitting in an offset account).

Investors will seek to set an EBITDA multiple, based on their qualitative and quantitative research into the business’s risk-to-return profile. Figure 1 provides examples of considerations that will be used by investors to determine the value of the multiple. This multiple will then typically be multiplied by the EBITDA generated by the business over its last twelve months of trading to produce the enterprise value.

Factors influencing a business's valuation multiple

A business’s EBITDA multiple can be influenced by a wide variety of factors, depending on the investment opportunity. Here, it might be helpful to refer to our home-buying analogy (Figure 2).

First, just as property investors consider the city or neighbourhood likely to offer the best return on investment, so do growth investors when they consider the growth and risk potential of the industry in which the business operates. They’ll want to understand the industry’s growth rate and whether the sector is bursting with new innovations, or if it’s a sunset industry on the decline.

Investors will also seek to understand current or potential macro trends as well as legal and regulatory issues impacting the industry. Most important, however, is for investors to understand how your business is positioned to navigate these and other ‘big picture’ challenges. Great business owners typically know their industry inside and out and are prepared to pre-empt any concerns investors might raise.

Just as a homebuyer who’s picked out an ideal neighbourhood then begins comparing specific houses, so do investors as they evaluate a potential investment against other opportunities in the market. As Figure 2 shows, investors will assess factors such as your competitive position and the growth rates of similar businesses. Importantly, they will try to understand how much other businesses, similar to yours, have sold for recently. Think of this as preparing a real-estate classified, just for businesses.

Lastly, just like a home buyer does during a building inspection, investors will dig into the finer, internal details of how a business operates. This includes getting to know the strengths and weaknesses of the leadership team and understanding their plans to grow the business.

Investors consider revenue projections and profit margins as well as the likelihood of those projections being realised. For instance, if a business has contracts in hand for a high portion of its projected revenue, this will give investors more confidence that the business can deliver as planned, compared to a business that is relying on estimates or new customers coming on board.

Another example of a risk factor investors will consider is your customer concentration – that is, the number of customers your business has, compared with the relative percentage of revenue they generate. This gives investors another opportunity to assess the risk associated with your projections. Businesses with few customers representing a large percentage of their revenue are generally inherently riskier than businesses with a highly fragmented customer base where the potential loss of a few customers is unlikely to result in a material decline in revenue.

Again, business owners can better educate investors of the potential upside of their business – or demonstrate how they can mitigate against the impact of potential risks – by putting their best foot forward. Being well prepared to answer tough questions about these and other critical business factors can make a big difference when it comes to pushing the valuation in the right direction.

What is a 'normal' valuation multiple?

Because EBITDA is selected as a proxy for the cashflow produced by the business each fiscal year, the EBITDA multiple represents the number of years of future earnings the investor is paying you for today to receive a stake in your business.

If your business is growing quickly, the investor might pay a high multiple today as they expect the earnings to increase, reducing the number of years of future earnings they need to recoup their investment.

Multiples are dependent on several factors. One factor is the industry your business operates in. Some industries require a lot of capital investment to stay competitive or grow their operations; others may be very low risk with favorable growth tailwinds.

Below are some indicative valuation starting points across various industries:

Industrials: 4-6x

Why? Significant investment (such as new equipment to increase capacity) is usually required to grow industrial businesses and they tend to generate lower profit margins. This means there is less cash to distribute back to the owners, so a lower multiple is paid.

Healthcare: 6-12x

Why? This is a resilient industry with a track record of consistent price increases backed by increased government funding and stable customer demand, usually coupled with low capital expenditure requirements. This means there is a low risk when predicting future earnings.

Software: 10-20x

Why? With a very low cost to provide an additional software license to an incremental customer and a potentially global addressable market, the gross margins in this industry are high, with rapid revenue growth directly resulting in rapid EBITDA growth. So, while an investor may pay 10-20 times on last year’s EBITDA, this could be equivalent to 5-10 times of next year’s EBITDA

While the above multiples are purely hypothetical and will vary across individual businesses within these industries, they demonstrate the relative valuation differences of industries.

Finding alignment

Investors and business owners might not always see eye-to-eye on the exact valuation figure. In that instance, different financial instruments such as convertible notes can help bridge the gap.

Convertible notes allow both sides to avoid setting a specific initial valuation while the business gets the funding boost it needs to realise its growth ambitions, and investors receive a discount on the future valuation.

Regardless of the specific mechanics of the offer, finding alignment with investors on your valuation is best achieved by building a relationship with your potential investors, ideally before you need to raise capital.

As a prominent investor once said: investors invest in ‘lines, not dots.’ Giving investors time to get to know your business, track your progress and learn how you navigate challenges in advance of a raise builds confidence and can make for a smoother investment process. Start the conversation early.

Similarly, business owners can generally take comfort that they are engaging with quality investors if sufficient time is being devoted to understanding all the major internal and external factors impacting the investment decision. If investors are rushing the process, and not taking the time to get to know you and your business to gain exclusivity on the deal, it’s worth considering what they are seeking to gain and whether the outcome will be in the best interest of your business.

Researching the valuations achieved by competitors or similar companies that have recently raised capital or speaking with previous portfolio companies about an investor’s process can provide the clarity and assurance business owners are looking for to guide their business into its next phase of growth.

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Australian Business Growth Fund (ABGF)

ABGF was founded with an initial capital of $540 million as a public-private partnership between the Federal Government and six leading banks. The Fund operates commercially and makes investment decisions independently of its shareholders. ABGF was set up to act as a catalyst for growth in the Australian SME sector by connecting founders and entrepreneurs to the capital, expertise, and wider networks they need to succeed.