- Potential investors need to agree on a business valuation with the business owner, before they will make an investment offer.
- While publicly traded companies can use their share price and number of shares to work out the business’s worth, private companies might use an EBITDA multiple.
- If the parties can’t agree on a business valuation, there are financial instruments and other strategies you can use to bridge the gap.
When considering a potential business investment, investors go through a process of evaluation similar to browsing real estate listings. Just as you would research a property before making a purchase, investors need to assess the value of a business before striking a deal. This evaluation process revolves around one crucial element: valuation.
The fundamentals of business valuations
To compare different businesses and industries, investors rely on a common financial metric to determine the value of a company. Publicly traded businesses have a straightforward business valuation process: the equity value is calculated by multiplying the share price with the number of shares. However, valuing private businesses requires a different approach.
“One commonly used methodology for valuing private businesses is the EBITDA (earnings before interest, taxes, depreciation and amortisation) multiple approach.”
One commonly used methodology for valuing private businesses is the EBITDA (earnings before interest, taxes, depreciation and amortisation) multiple approach. EBITDA provides insight into a business’s operational performance and acts as a proxy for the cash flow distributable to owners before debt servicing. The EBITDA multiple is a number applied to a company’s EBITDA to determine the enterprise value, representing the total value of the business.
Variables affecting EBITDA multiplesSource: ABGF. Click image to enlarge.
Investors set an EBITDA multiple based on qualitative and quantitative research into the business’s risk-to-return profile. Factors such as industry growth rates, macro trends, legal and regulatory issues, and the business’s ability to navigate challenges are considered. Additionally, investors compare the business with similar opportunities in the market, evaluating factors like competitive position and business growth rates. They also analyse internal details such as the leadership team’s strengths and weaknesses, revenue projections, profit margins and customer concentration.
Factors influencing a business’s EBITDA multiple
Each business’s EBITDA multiple for its valuation can be influenced by a wide range of factors, just as different aspects affect the value of properties in a particular neighbourhood.
For example, industrials typically have lower multiples because of significant capital investment requirements and lower profit margins. Healthcare businesses, characterised by consistent price increases and stable customer demand, tend to have higher EBITDA multiples. Software companies often have high multiples because of the low costs and high gross margins.
Property valuations vs business valuationsSource: ABGF. Click image to enlarge.
Finding alignment with investors
Sometimes it can be challenging to find alignment between investors and business owners on a business valuation. If so, financial instruments such as convertible notes can bridge the gap, allowing flexibility in setting an initial valuation. Building a relationship with potential investors before raising capital can also help in aligning valuation perspectives. You might also want to research valuations achieved by competitors or similar companies, and request feedback from previous portfolio companies.
“Sometimes it can be challenging to find alignment between investors and business owners on a business valuation.”
Understanding how investors value a company is crucial for business owners seeking investment. By investigating the factors influencing valuations and engaging in open communication with potential investors,owners can better position themselves to secure favourable deals that support their business growth aspirations.
Find out more
Looking for some more expert advice? The Australian Business Growth Fund (ABGF) was set up to act as a catalyst for growth in the Australian SME sector by connecting founders and entrepreneurs to the capital, expertise and wider networks they need to succeed. The fund aims to establish a long-term partnership with shareholders, emphasising collaboration and genuine support for a business’s growth.