Explained: How will an investor value your company?

When considering a potential investment, investors go through a process of evaluation similar to browsing real estate listings. Just as you would research a property before making a purchase, investors need to assess the value of a business before striking a deal. This evaluation process revolves around one crucial detail: valuation.

Valuations can be challenging for both business owners and investors to agree upon due to the potential upsides and downsides of every investment opportunity. However, understanding how investors evaluate a business can help prepare for discussions and secure the best possible deal.

Let’s examine the fundamentals of valuations

To compare different businesses and industries, investors rely on a common financial metric to determine the value of a company. Publicly traded businesses have a straightforward valuation process: the equity value is calculated by multiplying the share price with the number of shares. However, valuing private businesses requires a different approach, and a common language must be established between the owner and the investor.

One commonly used methodology for valuing private businesses is the EBITDA (earnings before interest, taxes, depreciation, and amortisation) multiple approach. EBITDA provides insight into a business’ operational performance and acts as a proxy for the cash flow distributable to owners before debt servicing. The EBITDA multiple is a number applied to a company’s EBITDA to determine the Enterprise Value, representing the total value of the business.

Learn how to get ready for an external investor

Figure 1: Variables affecting EBITDA multiples

Investors set an EBITDA multiple based on qualitative and quantitative research into the business’ risk-to-return profile. Factors such as industry growth rates, macro trends, legal and regulatory issues, and the business’ ability to navigate challenges are considered. Additionally, investors compare the business against similar opportunities in the market, evaluating factors like competitive position and growth rates. They also analyse internal details such as the leadership team’s strengths and weaknesses, revenue projections, profit margins, and customer concentration.

Factors influencing a business’ valuation multiple

Each business’ EBITDA multiple can be influenced by a wide range of factors, just as different aspects affect the value of properties in a particular neighbourhood. Business owners can educate investors about the potential upside of their business and mitigate risks by being well-prepared to address critical factors during discussions.

The valuation multiple depends on several factors, including the industry in which the business operates. For example, industrials typically have lower multiples due to significant capital investment requirements and lower profit margins. Healthcare businesses, characterised by consistent price increases and stable customer demand, tend to have higher multiples. Software companies often have high multiples due to low costs and high gross margins.

Figure 2: Illustrative comparison between assessing a business and property value

Finding alignment

Finding alignment on the valuation figure between investors and business owners can sometimes be challenging. In such cases, financial instruments like convertible notes can bridge the gap, allowing flexibility in setting an initial valuation. Building a relationship with potential investors before raising capital can also help in aligning valuation perspectives. Researching valuations achieved by competitors or similar companies and seeking feedback from previous portfolio companies can provide clarity and assurance to guide the business’ growth.

At the Australian Business Growth Fund (ABGF), we emphasise getting to know a business deeply before presenting a well-researched and fair valuation. ABGF aims to establish a long-term partnership with shareholders, emphasising collaboration and genuine support for the business’ growth.

In conclusion, understanding how investors value a company is crucial for business owners seeking investment. By comprehending the factors influencing valuations and engaging in open communication with potential investors, business owners can better position themselves to secure favourable deals that support their growth aspirations.