Jack Chang, General Manager – DGP Capital
One question that team members at my company, a boutique investment bank that provides mergers & acquisitions and capital advisory services, have been getting lately from both current and prospective clients is how interest rates can affect the valuations of private companies. Obviously we are in a market environment where a significant number of variables experience some degree of volatility.
The most important question I think is relevant to business owners, regarding the potential impact on valuation trends, is how much additional growth a company would need to have to counter any contraction in market valuation multiples.
In this post, I’ll dive into a few scenarios to illustrate why it might make sense to consider a trade when valuations are at historic highs, especially when it’s clear that rising interest rates will have some impact on future valuations.
Understanding what happens when EBITDA multiples contract
A vast majority of all private company transactions are valued on an earnings before interest, taxes, depreciation and amortization basis, also known as “EBITDA.” Simply put, EBITDA is multiplied by a factor, commonly referred to as the “EBITDA multiple.” The resulting product of the EBITDA and EBITDA multiple is the company’s enterprise value (ie valuation).
EBITDA multiples are largely determined by a combination of past transaction analysis, examining current market trends, and other valuation methods that your M&A advisor can help analyze your company.
For example, suppose your company’s 12-month EBITDA is $8 million. If the average EBITDA multiples for privately held companies of this size are eight, that further implies a current valuation of $64 million in enterprise value.
But if there is a contraction in valuation multiples across the board due to rising interest rates or other macro factors, it goes without saying that this has a direct impact on valuation. Valuation multiples could see a contraction from peak levels as supply of actionable deals begins to outpace demand. In this case, an EBITDA multiple dropping from eight to seven would result in a valuation of $56 million.
Getting the same appreciation when multiples fall
As multiples drop, business owners are often caught off guard when the offers they receive are lower than previous offers or estimates. Unfortunately, it’s a simple calculation: lower multiples result in lower valuations. But how does a company make up for this multifold decline and still get the same valuation from a crude dollar standpoint?
To get the same valuation as at its peak, a company must increase its total EBITDA and, in all likelihood, revenue. So the question then becomes, how much does EBTIDA need to rise to compensate for a decline in multiples?
For example, let’s take a company with an EBITDA of $8 million that could currently sell at an EBITDA multiple of eight. This implies an enterprise value of $64 million. Lowering the EBITDA multiple to six would bring the company’s valuation to $48 million. To hit the previous valuation of $64 million — taking into account the decline in the valuation multiple — the same company would need to have an EBITDA of $10.67 million. (You can calculate this by dividing $64 million by the new multiple.) Making up for the difference is a pretty difficult task to accomplish with strictly organic, steady growth.
Increase revenue/sales to achieve the same valuation at peak
Let us now examine these concepts in more practical terms.
As a business owner, you may be wondering how much more revenue or sales your business needs to generate to counter a decline in valuation multiples. The short answer is that it depends. A company with a higher EBITDA and/or a higher peak valuation multiple will require a different amount of growth to counter a decline in the multiples.
For example, consider a company that currently has $8 million in EBITDA and, at today’s peak valuations, would achieve a multiple of eight. Again, this results in a valuation of $64 million. Now suppose three years from now, EBITDA multiples/valuations across the board decrease by two, and at that point the same company would only receive a multiple of six, or a valuation of $48 million.
As noted above, to receive the same $64 million valuation as today, this company would need $10.67 million in total EBITDA. Assuming an EBITDA margin of 20%, this equates to over $13 million in additional revenue. (You can calculate this by calculating the difference between original EBITDA and new EBITDA divided by the 20% EBITDA margin.) Obviously, this is a difficult hurdle for any business to overcome.
Pack everything together
So what does all this mean, and why should an entrepreneur be concerned? My team often hears entrepreneurs say, “My business is doing great and I don’t think it’s time to sell, even if I’m thinking about retirement or an exit within the next few years.” But here’s the problem with that thinking: If you wait long enough in a peak M&A market, you’re likely to see valuation multiples fall, especially in a situation where interest rates are rising.
With a fall in the valuation multiple, your company will need to increase its EBITDA by a significant amount so that you can achieve the same valuation you would have received at the peak. As such, unless you are 100% confident that your business will grow in the near future, there is significant valuation risk associated with delaying a sale of the business or at least a partial liquidity event.
Therefore, if selling your business is a route you plan to take, it’s important to consider whether valuations are near the peak of a cyclical M&A market. This can help you determine when is an appropriate time to consider a full or partial exit to maximize the appreciation received for your business.
The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice on your specific situation.