In valuation there are rules of thumb, or sometimes more elegantly called valuation heuristics. An established, cash flowing company that isn’t growing fast (call it around 5% annual growth) but has stable margins will likely sell for around 5x EBITDA. If the company is growing faster than that, then the transaction multiples start climbing. If the margins are less stable, then the multiples start eroding.
The reason for 5x EBITDA isn’t something magical with the number. It’s just a central tendency over years and years of M&A, and seems to represent that point where a seller, looking to do something else, feels good about the value they’ve received in exchange for forgoing future cash flows. Conversely, the buyer feels like the price isn’t too high relative to how long it will take to recover and deliver a return on that investment.
Less stable cash flows make that return less certain, and therefore warrant a discount to the typical 5x EBITDA. Higher growth rates mean the return would come faster, indicating a higher price is needed to get the seller to be willing to part with those future cash flows. A high growth rate today doesn’t mean a high growth rate into the sunset, so the degree of comfort with future growth is also going to be factored into the multiple.
This all makes sense for established companies. But, the next question would be the rationale for paying transaction multiples of revenue for companies that may have little or no profit. Frequently, the buyers in these instances are either strategic buyers, or they are financial buyers expecting to eventually sell to strategic buyers. The public markets generally don’t love these unprofitable growth companies. There are plenty of exceptions, but as a general rule the public markets prefer strong profits.
The primary reason strategic buyers pay high transaction multiples is that they often view these companies as an alternative to investing in R&D that may lead to dead ends. These growth companies have gone out and proven in the marketplace that their business can generate revenue growth. So, for the strategic buyer it is less of a gamble. They crave revenue growth and have existing infrastructures that can be leveraged to absorb G&A expenses of the company they purchase. A company may not be profitable when it’s relatively smaller revenue has to support its own CEO, CFO, COO, CMO, VP of Sales, CTO, and all of their supporting organizations. But, plugged into a larger organization some of those high paying jobs can be eliminated and their support staff can either be rationalized or additional growth can be absorbed into established infrastructure without the need to add headcount.
Don’t feel bad for the high paying jobs as it is frequently their main goal. They don’t want to be cogs in a large machine. They view themselves as startup executives and they either move on to the next start-up or move to the Caribbean.
Now a quick concerning thought on “unicorns”. My concern is that many of these companies have outgrown their exit strategies. They don’t have a clear path to strong profits to make them viable public companies, and there isn’t a large enough buyer universe to absorb these private behemoths and pay the transaction multiples they were hoping and priced for by investors. They will need to figure out how to operate profitably, AND keep growing fast so public markets are not only receptive, but also willing to assign high valuations.
A good number of other factors play into transaction multiples, beyond just growth and stability of cash flows, but most are essentially leading indicators of those two key points. Management team, bench strength, market size, competitive positioning, and many other factors are just leading indicators of what generally leads to stable cash flows and continued growth.
If you would like to know the possible transaction multiples your business would fetch in an M&A situation or how to maximize those transaction multiples, EP is here to help.