Demystifying the Foundations of a Valuation

by | Aug 4, 2021 | Guides, M&A, Valuations

How much is your software company worth? The answer is complicated, and many business owners struggle to keep up with the variables and calculations involved in reaching it, whether they’re interested in selling or not. We recently hosted a webinar addressing this exact question, The Anatomy of a Valuation: What Your Company is Worth and Why. Joined by Bonnie Wilhelm, CFO, and Brandon Farber, Director of Finance of our parent company, the Perseus Group, we examined the structural parts of a valuation and how each factor can impact your bottom line.

Whether you are curious what your company is worth or are considering selling, we hope to help you gain the knowledge needed to understand how valuations are reached, the factors that impact them, and what you can do to drive value.

This article is the first of three, all of which will focus on unpacking the foundations of a valuation. Here, we will outline the anatomical parts of a valuation and answer questions we’ve received around them. The second article will explore value factors that drive valuations, and the third will wrap up the series by examining the risk factors that can negatively impact a valuation.

The Anatomical Parts of a Valuation 

Real world valuations are as much art as they are science, as value is subjective and means different things to different investors. The concept of multiples often leaves people scratching their heads, but really boils down to comparable analysis that evaluate similar companies using standardized financial metrics. The market value of these companies is based on factors like supply, demand, and returns. In this article, we demystify the foundations of a valuation by moving from subjective multiples to absolute terminal value by exploring the anatomical parts that make up a valuation.

Getting familiar with key terms 

There is a lot of complex terminology that gets thrown around when talking about valuations. The first step to understanding valuations is understanding the language and terms that shape them.

Business Valuation

Business valuation is the estimation of the current value of an asset or company. This value is based on various valuation methods, like future cash flows and market comparables, and can take any combination of the terms outlined below into consideration. The valuation process can be fluid and vary from buyer to buyer, depending on their unique goals, potential synergies the investment brings, and more.

Terminal Value

Terminal value is the present value at a future point in time, when a stable growth rate is expected forever.

“When we go to value a company, we’ll look at, say, five years of profitability,” Bonnie noted. “So, we’ll determine that in the valuation of the company. And then we’ll also value, at the end of that five-year period, what the company is worth. Then we discount it back to today’s date.”

Cost of Capital

Also known as the weighted average cost of capital, a company’s cost of capital is the required rate of return on an acquisition. Each buyer or investor might have a different required rate of return. Cost of capital is impacted by events such as a change in the cost of borrowing, or the buyer’s management team setting internal hurdle rates. More on these events later in this series.

EBITA

EBITA is an acronym that stands for Earnings Before Interest, Taxes, and Amortization. EBITA is used to evaluate the operating performance and profitability of a business.

When calculating the EBITA, ask yourself, “What is throwing the business off in terms of profitability?”

Margins

Margins represent the difference between revenues and expenses, which can be expressed as a percentage of revenue or in dollar terms. Typically, businesses like to see margins around 30%.

Your margins can be impacted by:

    • Scaling of your company, which can result in improved cost of sales
    • Growing revenue without increasing headcount
    • Improving vendor pricing and spending
    • Reducing interest expenses

Synergy

Synergy is when the combined performance of two companies will be greater than the sum of their separate parts.

You may encounter synergies when:

    • The owner of a company decides to retire post-sale
    • A company is sold to a large organization, resulting in better procurement pricing
    • Acquisition between two companies with varying customer base or geographies may allow the combined company to take advantage of cross-sell opportunities or increased demographic access, producing higher revenue.
    • The acquired company can take advantage of replacing onshore attrition at the acquirees offshore locations, leading to labor arbitrage savings

Deferred Tax

A deferred tax is an item on a company’s balance sheet that can be used two different ways. If you’re dealing with a deferred tax asset, it will allow the company to reduce their taxable income in the future, whereas a deferred tax liability will increase their taxable income in the future.

Working Capital

Working capital is the sum of current assets minus current liabilities.

When calculating a company’s working capital, we always ask ourselves, “Is this a capital-intensive business?”

Putting it all together

Whether you’re looking to sell, raise funds, or simply want to understand what drives the value of your business, understanding the anatomy of a valuation can help identify opportunities, costs, market placement, and areas of your business that might need attention. Knowing what drives and impacts your company’s value is the first step in increasing its valuation.


Questions from our webinar attendees, answered:

Are earn-outs usual?

We have them in a minority of transactions to bridge a valuation gap.  Usually the sellers are staying on for a number of years during the earn-out.

Do founders usually stay with the company post-acquisition?

Sometime founders are retiring or working on their next big thing.  Other times they want to continue to run their business with the added capability of acquisitive growth and buying their competitors.

Recommendations as to what owners can do while running the business to prepare for a successful exit in the future (and maximize the value)?

    • Groom a strong management team that can run the business without you.
    • Invest in long-term customer relationships that can help you evolve the business and increase share of wallet.

What are considered the most important measures when looking at seed-round valuations?

This is not our area, but we understand that the total addressable market (“TAM”) and ability to grow into that TAM are key.

How do you see rising taxes affecting valuation of US companies?

All things equal, a company is less valuable when the government takes more of its profits.

Are there any parameters for choosing the best discount rate for DCF valuations? 

Constellation does a discounted cash flow analysis that forecasts the post-tax cash flows of the business and allows us to calculate a purchase price that will achieve our Internal Rate of Return (IRR) hurdle rates. The rate depends on the size and risk profile of the business.

There seems to be this 10x revenue post $20mm revenue valuation in fintech. How do you value before $20mm? 

We do a discounted cash flow analysis that forecasts the post-tax cash flows of the business, allowing us to calculate a purchase price that will achieve our Internal Rate of Return (IRR) hurdle rates. The bigger businesses get bigger valuations and generally are given a lower discount rate.

If you have any questions or would like to discuss anything mentioned above, please feel free to reach out to us. We are happy to connect, anytime.

Best,

Tom

 

Tom George
President and Managing Partner
Constellation Real Estate Group
M: 310-734-0940