First off, to start at the basics. What exactly will be sold? Contrary to some beliefs, a Buyer is interested to buy the future cash flows of the Company and not its historic results. Some exceptions are possible, for example: in the case of specific assets, intellectual property or when a Buyer wants to eliminate a competitor. However, in most cases the future cash flows are what is important. So, if we want to determine the value of a Company we need to look at the cash flow it will generate in the future.
The higher the future net cash flows of your business, the higher the valuation
Free cash flow definition
The net cash flows which are used in the valuation of a Company are the so-called Free Cash Flows (FCF), which are defined as:
Earnings before interest, corporate income tax and depreciation (EBITDA)
Plus/minus: change in net working capital
Minus: capital expenditures
= Free cash flow (FCF)
What it means
The thinking behind the FCF is that this amount is the freely available cash a Company generates after deducting all its operational expenses and its expenses for maintaining its asset base (for example, maintenance of machinery or equipment). In other words, the net cash that is available to be distributed to the owners of the Company. Interest expenses are excluded from FCF as these are dependent on the way a potential Buyer structures the acquisition (completely with cash or with external bank loans). Depreciation is excluded as this is non-cash.
Most Buyers determine the value of a Company based on forecasting the future cash flows, which are used as input in a discounted free cash flow valuation model. However, for communication with the Seller they will refer to a multiplier against the Company’s earnings (for example, 5 times EBITDA or 10 times net result). A multiplier is a metric used to simplify Buyer and Seller negotiations and also used to compare the valuation of the Company with similar deals. An example, if a competitor acting in the same business has recently been sold for 10 times EBITDA, it is likely the valuation of your Company is in a similar range. Of course, no companies are exactly the same and these are indications for a valuation range only.
The multiplier is highly dependent on the sector your Company is active in and the demand for it. The more potential Buyers are interested, the higher the multiple. For Companies active in the IT sector (for example, cloud hosting solutions) high multipliers can be seen and multipliers are higher than 10. Generally, a multiplier varies from 5 to 10. Which means in other words, it takes 5 to 10 years before a Buyer has earned back its investment (not taking into account any increases in earnings or synergies).
Next to the sector your business is in, other Company specific items increase the value of your Company.
The following factors will increase the valuation of your business:
– Consistently growing revenues and profitability
– A loyal recurring customer base
– No dependency on a key customer (or key supplier)
– A high cash conversion ratio (meaning: low operating expenses and little required capital expenditure)
Of course, the opposite of these items decrease the value of your Company (e.g., high dependency on one key customer).
Determine the value of your Company
Determining the value of your Company is a very important and not an easy step. Many deals I worked on ultimately failed because of too high price expectations from a Seller. On the other hand, all Buyers will say your Company is worth less than what you expect. You do not want to sell too low as you can only sell your Company once! An external financial specialist (a so-called business valuation expert) can help you to determine the value range of your Company. They assist you in evaluating your future earnings, cash flows and know the multipliers used in similar transactions.
Before going into a sale process be sure to know the value of your Company, how this value has been calculated and be confident to defend it!
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