Originally published in Entrepreneur Country, 23 January, 2012.
Spreadsheets, revenues, customer acquisition costs, EBITDA, cash flow, burn rate….words that can make entrepreneurs turn to stone in fear and their anxiety bubble to bursting. There is no magic formula to making a small business become a great business, but there is a golden rule for ensuring the path is smooth; the management team, especially the CEO, need to live, breathe and dream the business financials.
From my experience with mentoring small and growing business, preparing, forecasting, managing and understanding the financials of their business are the biggest gaps in the arsenal of an entrepreneur. Entrepreneurs come to the table with brilliant ideas for marketing, strategy, operations and sales, but, more often than not, have no idea when it comes to putting the numbers together properly.
The first thing I do with any of my mentees is to dispel their fear of spreadsheets and show them how easy it is to put together some reliable and useful financial data. I take pride, almost shed a tear, when I hear them bandy about terms like “EBITDA” (Earnings Before Interest, Tax, Depreciation and Amortisation) with confidence, and see their comfort in contrasting their overheads (the fixed costs of a business; costs that cannot easily be removed and are not directly linked to revenue, this includes permanent staff) with their variable costs (such as costs of goods sold, costs incurred directly as a result of each unit sold/service rendered), and using the information to revise their operating plans to ensure better cash management.
I am not going to try and prescribe a standardised financial model – every business is unique, and, in my opinion, there is no set template. However, I do want to provide some (hopefully) simple guidelines on an important financial metric for any private business owner – how much their business is worth.
EBITDA is key
Net profit, revenues and costs are often falsely considered to be the most important factors when it comes to the worth of a business. Aside from the “king”, cashflow, the focus should be on EBITDA. EBITDA allows you to look at the performance of your business operations while eliminating all non-operating items, such as financing costs and tax, as well as non-tangible items such as depreciation and amortisation.
EBITDA Margin (EBITDA as a percent of sales) is extremely valuable because it helps you analyse whether a company is more or less profitable as a percentage of sales. A business should always understand if the new business it has added in the past year was as profitable as its past business, using the information to better allocate future resources to extract most value.
EBITDA margin also comes in handy when comparing companies of different sizes against each other and when potential investors or buyers are looking at the future prospects of a business. EBITDA margin will provide a true apples-to-apples comparison so that you can see which business’s operations delivers the greatest profitability on sales.
Straightforward valuation – using comparables
The use of comparables provides a quick and easy way to obtain a ballpark valuation for a business. In my experience, it is the method most frequently used to assess equity investment as it incorporates the intangible factor of market sentiment (demand) into the valuation. Young businesses use the metric to predict a future (exit) valuation to convey the returns possible for the investor(s). To make things simple, using a standard rule of thumb (given that forecasts are unreliable), a multiple of 5 times EBITDA (5xEBITDA) is acceptable.
More scientifically, find firms listed on stock markets or firms where financial and valuation data is publically available that display similar “value characteristics” to your business. These characteristics include, industry, product/service, risk, growth rate, capital structure (% of debt and equity), and the size and timing of cashflows. Look at their EBITDA multiples and average across them:
|Your EBITDA multiple =||(market value of firm 1 ÷ current year EBITDA firm 1 + market value of
firm 2 ÷ current year EBITDA firm 2 +……etc.) ÷ no. of firms
Note, to forecast future value use the EBITDA from your forecasts for the year in which exit for the investor is planned, usually 5 years hence/the year for which you want the valuation. However, using today’s multiple does not account for changes in market sentiment over time.
There are other comparable measures that can be used, such as Price/Earnings ratio (P/E) and market-to-book ratio, but these are not as reliable as the EBITDA multiple. For example, the P/E ratio does not account for the differences in capital structure of a business (earnings include interest deductions), a key factor in valuation.
Accounting based comparables such as P/E are also not particularly appropriate for unprofitable companies experiencing rapid growth. These accounting ratios have been shown to have little predictive ability for IPOs and vary greatly amongst publicly traded firms in the same industry.
Venture Capital Method
As it says on the tin, this method is often employed in the Venture Capital industry to calculate the percentage ownership a VCrequires for an initial investment in a firm, particularly one that has negative cashflows and earnings but with significant, yet highly uncertain, growth potential. A business owner can thus pre-empt and be better prepared for negotiations by understanding the valuation methodology.
The method essentially values the business at some future point when it has achieved positive cashflows and earnings and the VC may look to exit, be it via IPO or private sale. This “terminal value” is then discounted back to today to calculate the % ownership the VC requires, factoring in their required rate of return and estimated dilution in future rounds of financing.
There are four key steps to the method.
Step 1 – calculate terminal value. Multiply the projected net income in the exit year by a “comparable” metric (as described in the previous section). In this instance, it may also be worth scouting for comparables for VC exits of similar businesses. Alternatively, you could be more scientific and use a discounted cash flow method as described later.
Step 2 – Calculate the discounted terminal value. The terminal value is discounted back to a representative value in today’s money, based on the target rate of return (yield) the VC wants to earn on the investment. This rate of return has to adequately justify the risk and effort the VC undertakes on the investment – typically this number is between 40% to 75%.
Discounted Terminal Value = Terminal Value ÷ (1 + Target Rate of Return)Years of investment
Step 4 – Estimate future dilution and calculate current ownership percentage. Seldom does one round of financing enable all future potential. The VC (and so should you) expect further rounds of financing to occur, each one assumed to “dilute” the initial equity holding of the VC. No golden rules here, a little finger in the air, but assuming two further rounds, one potentially being an IPO, each selling 25% of equity, is probably cautious enough for a start-up, lower if a more established business with proven revenues. The “Retention Ratio” of the VC has to be calculated and then applied to the required final % ownership to discover the initial current percent ownership required, and hence the value of the business (in the eyes of the VC).
Retention Ratio (%) = 1 ÷ round 1 equity % ÷ round 2 equity % … ÷ round n equity %
Required Current % Ownership = Required final % ownership ÷ Retention Ratio
Value of Business = VC Investment ÷ Required Current % Ownership
With the advent of new business models, particularly those that are internet based such as social media, it is has become difficult to estimate business value. There are few direct comparables and thus high uncertainty over future monetisation of the business model. Think Facebook, LinkedIn and StumbleUpon or businesses that rely heavily on advertising revenue. New, slightly orthogonal, yet intuitive techniques are being used to provide a valuation of the business, be it for use as an input into the more traditional models such as NPV, as an alternative comparable multiple, or as an outright measure in their own right. Below are a few suggestions.
Customer Lifetime Value: Business value is a factor of the goods and services the business sells, which in turn is a factor of customer purchasing habits. As such, calculating the value that your customers contribute to your business over the lifetime that you hold customer relationships should give a good estimate for how much your business is worth. This methodology is a crude approximation of the Net Present Value technique (below), focusing on direct costs of servicing customers, ignoring other aspects of overhead that may be incurred.
|CLV =||[(Customer margin generated per year – other direct costs, e.g. marketing)
÷ (1 – retention rate + discount rate)] – Customer Acquisition Cost
Customer margin = % margin per purchase x price x no. of purchases in the year
Retention rate = the probability, per year, that you retain your customer
Discount (Interest) rate = arbitrary discount rate for discounting value of money to today, e.g. 10%
Customer Acquisition Cost = The costs involved to acquire a customer – e.g. spending on SEO ÷ conversion rate, direct mail or telesales costs ÷ response rate, credit checks, legal costs, etc.
The above equation will give you the lifetime value of one customer in perpetuity. For a mature business where customer acquisition has relatively stable growth each year, the value of the business can be estimated as follows:
|Business Value =||CLV x number of customers acquisitions in the next year x (1 + yearly customer growth rate) ÷ (Discount rate – yearly customer growth rate)|
Note: Growth cannot exceed the interest rate (more accurately, the weighted average cost of capital, described in the NPV section below). If it is expected that growth will exceed the discount rate in the short term, the formula needs to be split in order to accommodate the rapid initial growth period:
|Business Value =||Sum (for years t = 1 to N) [CLV x customer acquisitions x (1 + initial growth rate)t ÷ (1 + discount rate)t] + [CLV x customers acquisitions x (1 + initial growth rate)N+1 ÷ (Discount rate – stable growth rate) ÷ (1 + discount rate)N]|
Where t from 1 to N is the number of years for which the high growth rate is expected.
In order to make the above an even more precise reflection of business value, customers should be segmented as much as possible into broad purchasing categories with their own values for margin, retention rate and growth rate. E.g. loyal vs occasional buyers. Large corporates v SME, etc. The above formulae will need to be calculated for each customer segment and summed to calculate business value.
For even further precision, the CLV can be calculated more specifically, incorporating variable margin and retention rate information for the first few (N) years, potentially 5, using the formula below. The values for the final year, year N, can then be extrapolated in perpetuity using the formula above and added in to the calculation.
|CLV||SUM (for years t =1 to N) [Margint – other direct costst) x retention rate (t-1) ÷ (1 + discount rate)t]
+ [(MarginN – other direct costsN) x retention rate N ÷ (1 – retention rate + discount rate)] – Customer Acquisition Cost
Intangible Assets/non traditional multipliers: Increasingly becoming popular in the valuation of young internet businesses, Intangible assets and revenue itself, core drivers of business value, are being used in lieu of EBITDA as a multiplier. Using the same principles as with the EBITDA multiple, find businesses that have a similar risk and business profile to your own, be they publically listed or where the appropriate numbers can be acquired, and use an average across the firms to calculate an appropriate multiplier for your own business. Some examples of multipliers used:
a) Subscriber multiple, e.g. where the network of signed up users is the key to monetisation, be it online, publications, mobile = Business value per subscriber
b) Page view multiple, e.g. businesses that have a heavy reliance on online advertising revenues = Business value per page view
c) Revenue multiple = Business value per unit of revenue.
d) Asset multiple, e.g. wholesalers or asset management firms = Business value per value of assets held/under management
As the key metric for value is margin, it would be worth adjusting the above multiples to account for potential differences in margin between the comparator company (ies) and your company:
Observed multiple x [your company operating margin ÷ comparator company operating margin]
Net Present Value based valuation
Note: This may look complex at first to some, but when done in a spreadsheet such as Excel, it is really not that difficult. An example is provided at the end.
Taught at Universities and business schools, the NPV method is a well known cash flow valuation method used, for example, in assessing the present value/price of a stream of payments on financial instruments such as bonds. It has been borrowed for use in valuing businesses; ultimately, the current value of a firm is a factor of its future earnings potential.
This method is most appropriate for more mature businesses with stable growth, where future cashflows are relatively predictable. New ventures experiencing rapid growth and expansion should not use this technique except, to benchmark against a comparable type valuation. Venture Capital firms and other investors will place little faith in cash flow projections beyond a timeframe of 1 year to 18 months.
One of the major benefits of the NPV method is that it incorporates the benefits of tax shields resulting from interest being paid on debt owed by the business. As such, interest should be deducted from the cashflows used in the calculation. Without going into the details of why, for each month of your financial projections a value called “Free Cash Flow” is calculated as –
|FCF (at time t) =||EBITDAt x (1 – Corp. Tax rate) – Capital Expendituret – increase in Net Working Capitalt|
Net working capital represent operating liquidity within the business calculated as:
Current Assets – Current Liabilities, excluding deferred tax assets/liabilities, excess cash, surplus assets and/or deposit balances
Next, we need to calculate the “Terminal Value” of the business – what the stream of earnings beyond your projections are worth (ad infinitum; in perpetuity). This is important, as the bulk of a business’s value is often in the terminal value. It is calculated using the following perpetuity formula, where g represents a rational growth rate for future earnings (remember to consider the timeframe for which you are doing this – monthly growth rates will be lower than yearly ones), and r represents the discounting rate, the Weighted Average Cost of Capital (WACC) – calculated further below:
TV (at time T, the final time period in your projections) = [FCFT x (1+g)] ÷ (r-g)
The discount rate (WACC), r, is calculated as follows (bear with me on this one):
r = [D/V] x rD x (1-Tax rate) + [E/V] x rE
D = The value of debt in the business
E = The value of equity in the business
V = D + E
rD = discount rate/cost of debt
rE = discount rate/cost of equity
If you want to be really specific, you should use the target capital structure for the business, i.e. the target values for D and E, but then we get into a somewhat messy issue with the following calculation, needing to “un-lever” then “re-lever” the beta – let us not go there!
To calculate rE , the return expected by market investors on equity:
rE = rf + β x (rm – rf)
β (Beta) = degree of correlation with the market; can be found for comparable firms listed on the stock market using Google search
rf = risk free rate; typical is to use a government bond yields, say for 10 year UK gilts.
rm = Rate of return on (comparable) stock over a period, typically 10 or 5 years.
(rm – rf) = The market risk premium; to avoid complexity, 7.5% is a typical premium that can be used.
rD is straightforward; it is the rate at which you (can) borrow capital.
Now (finally) you calculate the business value. IMPORTANT – remember to adjust the r to reflect the right time period, i.e. typically, r is calculated on an annualised basis so when applying to monthly cashflows you need to divide the r by 12.
Firm Value (NPV) = [FCF1 ÷ (1+r)] + [FCF2 ÷ (1+r)2] + [FCF3 ÷ (1+r)3] +…..+ [(FCFT TV) ÷ (1+r)T]
The following is how I typically structure it in a spreadsheet with financial info, as I said, not as complex as it looks, when you take it bit by bit.
Illiquidity and control adjustments
If valuing your company on account of raising additional equity capital or considering a private sale, you must recognise that the buyer will undoubtedly apply an illiquidity discount to whatever valuation is arrived at by any of the methods above. Equity investors want to factor in the cost of liquidating their position quickly should they need to. As the equity is not publically traded on a stock market, the buyer will argue that they would need to consider 20-30% discount on value to sell on the equity. Hence, they will adjust your business valuation downwards by that percentage.
Private equity investors buy into companies for 4 key reasons:
• Tax arbitrage
• Debt (leverage) arbitrage
• Governance arbitrage
• Regulatory arbitrage
Now, you may uncover that the driver for the investment/buy out is governance arbitrage, i.e. the buyer believes that your business is not well run and wants to instil new management and new strategy to enhance business value in the future (bite your own ego on this one!). If this is the case, you can presume that they are attributing acontrol premium to the business; adjusting the value upwards by a percentage to account for the potential change in strategy and management. A control premium can also be assumed in most strategic investments, where a corporate is buying your business due to synergies (consolidation, combination, connection, co-creation) that may be realised through ownership. Bear this in mind when negotiating the selling price!
I have tried to make the above valuation methods as simple but as comprehensive as I can. There is no precise science, only best estimates. Hopefully you will now have the ability to compute a business valuation that you can have some degree of confidence in, for whatever reason you need it.
There are a number of additional factors that you can think about when valuing the business. With the Net Present Value methodology, incorporating the future capital structure of the business, as best as can be envisaged, and adjusting the WACC accordingly by levering and unlevered the beta, will give a more reliable enterprise value and is particularly apt when the business is being acquired through a debt backed/leveraged buyout. Those mathematically inclined may have noticed that there is an optimal balance between debt and equity to achieve a maximum valuation given any series of cash flows – often a driver for a PE firm acquisition. There are also a number of other ways to estimate beta using accounting information if a reasonable comparable cannot be found.
Below is a summary of the strengths and weaknesses of each method I have presented. Please do contact me if you have any further questions or would like to discuss/contribute to the information I have detailed here.