EXIT STRATEGIES: Forget the multiple

exit-sign1_200If you are serious about selling your high growth potential business then it might be best if you erase from your mental models whatever you have learnt about business valuation because I can assure you it will simply get in the way of you achieving a high premium on sale.

Few people understand high growth ventures and even fewer understand how to value them for sale. In fact, to be really honest, selling a business is not about valuation, it is all about creating a compelling opportunity for the buyer.

Think for a minute about the manner in which you take a product to market.

Without exception, you would start with the problem you are solving and then proceed to identify the customer you wish to address. Your focus is always on creating value for the customer. Why would they buy from you and not the competitor? What could give you a stronger competitive advantage? What approach would you use to put your solution in front of your target customer?

How is it that we forget the basics of creating value when we come to sell the most important product we have – our business.

Instead of handing over the problem of selling your business to a stranger, start the process by thinking of your business as a product which you are going to package for a very selective customer – the buyer who will pay the highest price. With this enlightened approach, you will find the Ultimate Exits model
compelling.

High growth ventures are different

When you know your historical revenues and profits significantly undervalues your business, you can be forgiven for getting irritated at the professional advisors who tell you your business is only worth some small multiple of your current net earnings.

I have talked to numerous entrepreneurs who are planning the sale of their business who are totally frustrated with the valuation formula used by their professional advisors. They rightly argue they have spent their surplus funds in developing the potential of their businesses but they cannot see how this is reflected in their valuation. They are constantly being told to cut back on development costs and expenses and ramp up their profits to increase their value but this appears to be counter intuitive. Surely, they argue, a business with greater growth potential must be worth more than one which is just crawling along but has higher current profits.

They are right. The valuation methods applied by the vast majority of professional advisors, business brokers and investors have been developed around conventional businesses and were never designed to take high growth potential into account. So of course, the valuation calculated by their advisors does not make sense to the high growth venture entrepreneur.

The current methods of business valuation are backward looking. By that I mean they look to historical performance to measure a firm’s worth. The assumption is that what was achieved in the past is most likely to be achieved in the future and this is the best indicator of the firm’s future capability. Of course, if you remove this assumption, most advisors are lost in the wilderness and have no methodology and no theoretical models to enable them to develop a valuation.

If you are an early stage venture with little or no revenue history, they throw their hands into the air and state that they can’t possibly value a business without documented historical performance. My own experience of high growth ventures has shown me that using a conventional valuation as a guide to an exit valuation is almost always inappropriate and, usually, completely misleading.

Pioneer Computer Group

The first business I sold was a software business. Three of us had started the business in a dining room in the UK in 1979 and had grown it to 160 employees by 1991 when we sold it. That is a growth rate of about 36% pa, so it qualifies as a high growth venture. The business raised $1.5 million in venture capital, undertook two acquisitions, had offices in three countries and worked with over a dozen distributors around the world. In the last few years before the sale, we released the world’s first ERP system for process manufacturing based on a relational database and a highly productive applications development system, both of which are still alive and well 20 years after being first released.

The business was generating revenue of about $10 million and a net profit of about $500,000 by 1990 when we decided to sell. Valuations at the time were about 4 x EBIT, so a sale at $2 million was possible. However, even then we thought this undervalued the business due to the potential of its innovative products. We had spent 22% of revenue on product development for many years when the industry norm was around 12%. Products like ours could take 5 to 7 years to bring to market and yet we were still being valued purely on our
current performance. It seemed at the time to be grossly unfair but that was the prevailing valuation norm.

However, luck went against us in 1990 as the UK plunged into a recession. Instead of a profit, we found ourselves at breakeven with revenues declining by 20%. A business which was profitable was now worth very little. What is a business worth which has declining revenue, no profit and facing significant staff layoffs? Even though we had about 50% recurring income and would survive, it would still take several years for the economy to pick up and for us to get back into profit.

We abandoned our plans to sell the business to one of the larger software conglomerates in the UK and looked abroad to the US to find a buyer. We decided to take a different approach. Rather than sell on the basis of our
profitability, we would sell on what we could bring to the table with our market leading products. With some research into the US market, we finally decided on Ross Systems, a software company specializing in corporate financials, as our target buyer. Our approach to them was that we could assist them to enter the emerging process manufacturing software market away from the crowded corporate financials market and our development system could take them to the forefront of technology.

Ross were interested enough to invite us to a meeting in California. The result was they decided to enter into negotiations with us as soon as they had listed on NASDAQ, planned for the middle of 1991. Immediately after the listing, they begin serious negotiation and due diligence. Several weeks later we signed a contract to be acquired for Ross shares worth $9.6 million. At the time of sale our growth had stalled due to the recession in Britain, we were making a monthly loss and our prospects looked fairly bleak for the next few years.

Using a conventional valuation approach, our business would have been worth a fraction of the price paid, perhaps only some small value for the net assets of the business. Why did Ross willingly pay about one times revenue?

Unless we can provide a convincing answer to this question, we do not have a comprehensive theory of valuation. If our conventional EBIT multiple valuation approach does not explain this sale price, what valuation model can we use?

Clearly this valuation is about potential, not the seller’s, but the buyer’s. Unfortunately, conventional approaches to valuation do not take into account the buyer’s potential in arriving at a valuation, yet potential is what high growth firms spend their time building.

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