How to Value Private Companies for M&A Purposes

Intro

This is a question that I get a lot. Especially in the context of a buyer looking to make an offer or bridge a valuation gap with a seller. While there is no right answer, there are best practices. I'll start with some common options that usually don't work.

What (Usually) Doesn't Work

• Relying solely on market multiples: "let's pay the same multiple someone else did" While this data serves a purpose, it often requires adjustment (ie. to account for size differences) and lacks important context (ie. how is a future contingent payment accounted for?). Further, private company transaction data is often difficult to find.

• Relying on seller expectations: "the seller wants X and I think we can justify that" While seller expectations are important to understand, they are often biased upward, fail to consider what the company will look like under the buyer's ownership and are not reflective of what the buyer can or should pay.

• Sticking to a number: "I don't want to pay more than [X]x EBITDA" While buyers should exercise investment discipline, valuation is not as simple as EBITDA times a multiple. [X]x EBITDA might be appropriate for some deals, but not for others. The situation needs to be assessed in detail.

• Hiring a professional valuator "let's use an independent valuator to determine price" While these professionals serve an important role in certain situations such as internal transactions and litigation, a buyer-funded advisory report rarely gets a seller across the line because valuation is highly subjective and could be biased.

So What Works?

• Having an investment scorecard An investment scorecard allows buyers to assess acquisition targets against their desired criteria, and only proceed forward with the opportunities that meet their investment criteria.

• Having internal return targets Internal return targets set out the return that the investment must achieve in order to be successful. This return can be expressed over the life of the investment (ie. IRR), annually (ie. ROIC) or other (ie. Payback).

• Modelling out the projected cash flows of the business A forecast allows the buyer to project how much cash flow the business will produce in the future, and then use that to determine today's value.

• Making an offer that meets return targets Once the modelling is done, the buyer can solve for the price and deal structure that allows them to achieve their return targets.

So What is an Appropriate Return Target?

The answer is that it depends on a number of factors. As a starting point, the S&P 500 which is comprised of large established companies, generally returns an average of 10%/year. Private company acquisitions, which are smaller and much risker, command a meaningful premium in most situations. The required return on a private company investment could be anywhere between 15-35%/year.

But What About Market Multiples?

Market multiples can be used as a secondary reasonability check, if they are available. Careful consideration should be given to (i) the source of the information, (ii) the structure of the transaction (and how that compares to the buyer's structure), and (iii) the size of the acquired company (and how that compares to the target company).

What about seller expectations?

Buyers should never pay more just because a seller wants more. Buyers can however use seller expectations to influence their offer presentation and deal structure. For example, if a seller has high expectations, the buyer might utilize a deal structure with future payments that are contingent on that future growth.

In conclusion, valuation should be driven by a critical assessment of the target company relative to the investor's scorecard and return requirements, not based off of other external data points or opinions.

At M-Squared Advisory, we view every client project through the eyes of an investor, drawing on past transaction experience. We have the expertise to help clients define their valuation approach and support with the valuation process.

If you are thinking about investing in private companies or need help with valuation, we can help. Reach out here.