Valuation (the price one party will pay another for a business in an M&A transaction) is based on what you can negotiate. And, as with most negotiations, valuation is more art than science. In fact, some call it alchemy because valuation is often subjectivity masquerading as science and logic.
Valuation is really the intersection of cash flow and time. In other words, how long will the Buyer take to recoup the cost of the investment? And how many years’ worth of profits is the Seller willing to take today in exchange for giving up an infinite flow of profits from that business?
Keep in mind that cash flow and time aren’t the only contributors. You also need to factor in the following:
Future prospects of the business: Is the business growing rapidly? Is growth stagnant and flat? This growth (or lack thereof) may affect how much Buyers are willing to spend.
The risk associated with the specific business: For example, are the company’s products high quality, or has quality slipped? Is the company able to recruit, train, and retain good employees, or does it have a problem with excessive employee turnover?
Systemic risk: Systemic risk is risk affecting everything in the economy. The recent economic meltdown is a perfect example (unfortunately) of how the economy can affect everyone and every company. Plenty of well-run companies offering good products and services suffered due to a widespread downturn. Buyers feel a lot less generous in the valuation process when systemic risk is high.
Cost of capital: Cost of capital is another name for “what else Buyer can do with that money.” If Buyer has other options, he deploys that capital in those deals that offer higher returns and less cost.
And, on top of all that, valuation depends on negotiating prowess. In other words, are you a good poker player, or do you fold and collapse when someone puts a little pressure on you?
Most often, valuation boils down to a small, simple valuation range: four times to six times EBITDA (or 4X to 6X in M&A code). The magic number in the M&A deal-making world is smack-dab in the middle: 5X. These numbers are known as multiples, so when you hear someone say “a 5X multiple of EBITDA,” that person means a company with EBITDA of $3 million would have a $15 million valuation.
Five times EBITDA is an industry standard, a convention of deal-making. Nobody knows where 5X came from, but all you need to know is that it’s a de facto standard. In good or bad times, that multiple may be a bit higher or lower.
As Seller, you can get a valuation higher than 6X, but you need to have a strong negotiating position. The best negotiating position is to have a highly profitable company in a rapidly growing industry.
For example, venture capital deals usually garner far higher multiples for Sellers than lower middle market and middle market deals do. In a venture deal, Buyer is willing to pay a higher price because he’s expecting the company to grow rapidly; he’s betting on the future prospects of the business.