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3 Valuation Tools – They’re for support; they’re not gospel

by on June 18, 2013

ToolsValuation methodologies are just tools.  They are used to derive a value for a company.  And valuing a private company is difficult.  Valuing a private, small, tech company is very hard.  It’s good to know what those tools are.  Every CEO and CFO needs to be aware of them.  M&A professionals need to be experts in them.  But when it comes down to negotiation and agreeing on a price, whether its for an acquisition or an investment, they’re nothing more than tools.

Ultimately, the value is determined by people negotiating with people.

The different models that are used to value a business and are apart of every executives M&A toolbox are: the Income Approach, the Market Approach, and the Asset Approach.  Within each of these approaches there are several methods.

Valuation Methods

In technology, especially in software, the income approach and/or the market approach is used most frequently.  The asset approach isn’t as relative because the assets of software companies are primarily the people and the IP.  It’s not machinery and real estate.

The interesting point about using the income approach is that it’s typically based on a valuation relative to profitability, measured in EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortization).  However for many startups and small technology companies there isn’t a positive EBIT or EBITDA  but the companies are still valuable, even using the Income Approach.

Valuation for most software companies is measured based on Revenue, often the last 12 months referred to as trailing twelve month (TTM) revenue, but also the last fiscal year, and the next 12 months.  This is the approach used most frequently for smaller software technology companies.

A company can be valued based on some multiple to TTM Revenues.  For example, a company generating $50 MM in TTM revenue could be valued at $200 MM using a multiple of 4x.  The muliplier is a function of perceived growth versus perceived risk.  The higher the number, the greater the growth vs. risk.  The lower the number, the greater the risk vs. growth.

What multiple to use is often determined by using the Market Approach.  What are comparable public companies valued at?  What did comparable private companies sell for as a multiple to TTM revenues recently?  This data is extremely useful to set expectations for a company’s value.  The details for determining the valuation of a private company were explored in a previous post, How Much is my Private Company Worth.

While the method of valuation is important and the resulting value is very important, the CEO needs to realize that neither the number nor the method to derive that number is gospel.  If each party in a negotiation, including a potential investor, agreed on a valuation method and agreed on the assumptions of that model, the resulting valuation would set the price of the company.  But each party has their own perspectives and assumptions and that leads to different valuations for the same company using the same data.

In one of my negotiations to buy a company our bid was substantially less than the seller was looking for, and they ultimately received from another buyer.  But in our negotiations one of the tactics they took was to try to get me to agree to a valuation method, and based on the assumptions they used, assuming we agreed, they thought they’d convince us that the valuation they were looking for was justified.

But the underlying premise didn’t work, in this case.  We didn’t agree on the assumptions and therefore we had different valuations for the company.

As I stated, they eventually sold to another party at the price they were looking for.  Were they right and we were wrong?  No.  We just weren’t the right parties for each other.

What’s important to determine the valuation of a company is what the buyer or investor and seller accept.  How else can you explain a $1 billion valuation for Waze or Instagram?  Those valuations are not justifiable using any method described above.

Those valuations were agreed to because that is what the sellers were willing to sell for and the buyers were willing to pay.  The rationale to support those numbers, which will be left to the accountants to articulate in the financial statements, was something other than a valuation model.  They were based on growth, revenue, a competitive bid situation, keeping a competitor form buying the technology, and because they could.

So don’t get bogged down in valuation models.  They’re just tools.  They can provide a comfort level and a reality check. Focus on the deal at hand and the opportunity before you.

p.s.

If you’re wondering how you build a company that you can sell for a premium in a few years, contact me to discuss the Valuation Amplification Process.

I also invite you to download the white paper and learn the 5 step process on How to Quickly Increase Your Valuation: a Proven 5 Step Process.  http://www.therevenuegroup.net/free-offer.html

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