As you might expect, sellers look for a premium multiple. Buyers typically will only consider paying a premium to market if they are adequately convinced that the value of the potential target justifies it.
This begs the question: How does one derive a rationale for discount and premium multiples on a business?
There are a number of factors that contribute to and ought to be considered when assigning a discount or a premium to a market valuation multiple. Typically when using the term “multiple,” we are referring to EV/EBITDA or EBITDA multiples. Sometimes Revenue Multiples are applied when EBITDA data is not available.
Here are some factors that buyers and sellers consider when evaluating a business that may lead to premium valuation:
Customer diversification
A more diverse customer base is looked on more favorably than a heavy customer concentration, even with a blue-chip company. The risk of a big customer leaving after a transfer of control will typically be reflected in lower valuations from a bidder. Customer diversification may refer to geographies, product lines, end-users, or market segments. Anything that reduces the risk of a significant disruption or potential variability of revenue streams is a source of valuation premium.
Financial controls and accounting systems
Are there financial systems in place? Are statements audited? Audited financial statements are especially important to buyers because they demonstrate a level of sophistication and accountability in the seller’s business. Companies with their house in order from a financial, operational and accounting standpoint will command higher multiples. At the same time, having these functions organized makes diligence quicker and easier for the buyer. This reduces deal risk and improves the probability of a successful close.
Recurring revenue streams
If a company’s revenue is more recurring in nature, it can command a higher multiple than a business that needs to find new customers in order bring in revenue. A subscription-based business is very attractive to buyers because the money keeps coming in without any additional sales. For example, Netflix only needs to sell its services one time to a subscriber. After that, each month Netflix is guaranteed $7.99 without doing anything. On the other hand with a single-sale business, the company has to expend time, money and resources to ensure another sale to keep the money flowing in.
Past growth and performance
The past is often used as an indicator of future performance and a company with a history of sustainable growth will get a premium.
Sales pipeline and voracity of projections
The bigger the sales pipeline and the quality of the pipeline, the higher the premium. The credibility of the future revenue streams is also important. The more verifiable and believable, the higher likelihood of harnessing a premium valuation based on the potential growth in the business.
Management team and leadership
The experience, track record and quality of the management team are all taken into account when valuing a business. An experience team of executives who have worked at the business for a number of years will fetch a premium.
Human resources and staff
Training resources and protocols, quality human capital, well-functioning human resource systems and a track record of retention of key employees are all important aspects to consider when assigning discount or premium. The better these structures are when compared to similar businesses, or peers, can drive higher valuations as well.
Logistics, distribution strategy and operation infrastructure
What channels does the company use to reach the market? How efficient are distribution networks? What kind of infrastructure is in place and what is its quality? Companies that need additional CAPEX to shore-up holes in this area will typically command lower valuations.
Preparation – How well is the table set for a transaction?
On a whole, how prepared the seller is for sale will affect the valuation multiple. The more prepared the seller is, the more likely the business is to fetch a higher multiple.
Buyers and sellers may evaluate some of the attributes above in order to determine if the company deserves to be assigned a discount or a premium valuation. Ultimately, however, “the right multiple” is the one that the buyer and seller come to agree on, so don’t get too caught up in the technicalities or if you’ve checked all the boxes. Depending on the particular strategic rationale for sale, one of the items above may be more important than another. Valuation aside, nothing is more important than getting the transaction rationale right. Valuation is a tool for evaluating a potential acquisition that informs us on appropriate deal structure and allows us to begin exploring financial and operational due diligence from a quantitative perspective.
