Frank and Wanda (not their real names) are avid golfers. Members at one of Nashville’s finest country clubs, they play at least once a week. They even take an annual golf vacation, sometimes to the home of golf in Scotland.
I recently met Frank and Wanda via a Zoom call on the recommendation of their wealth planner. They are interested in selling the company they started in the late ‘90s. They told me they decided to sell their company after meeting a guy during a golf trip to Scotland last year. It seems this guy sold his company for a bundle. He had confided to Frank and Wanda that he got a “12X deal” from a private equity buyer.
So what do you think Frank and Wanda are assuming they will get for their company? You guessed it, they have 12X in mind. Suffice it to say, they are excited to sell and start playing a lot of golf at some very nice places for a long time!
I hate to be the bearer of bad news, but sometimes I am forced to play that role. I had to explain to Frank and Wanda that, assuming the guy was telling the truth about his 12X valuation, it would be an outlier, not the norm. In my 25+ years of deal-making, I’ve seldom seen a business transaction get too far outside the norm of valuation. While there are myriad factors that affect private company valuation, when I see a business with EBITDA greater than $3 million, strong margins and demonstrable growth potential, more times than not, I will project a valuation of 7-9X EBITDA. If an M&A advisor starts making claims about getting more than that, they might not understand math, and here’s why.
The private equity (PE) model is premised on generating within six years a 3-to-1 return on invested equity. Of course, that doesn’t always happen, but that’s the plan going in. So assuming PE will buy the company with 50% of the value financed with debt, they have to see the company valuation double to a derive 3-to-1 return on invested equity. This construct is their guiding principle whether they buy a company for 4X, 7X or 12X. But here’s the rub, most banks/fixed capital investors will not lend more than 3X on a transaction. So if the total valuation goes beyond a 6X, the PE buyer has to invest more equity, and that makes getting their 3-to-1 return increasingly difficult.
Yes, there will be outliers, I’ve handled a few and it’s a beautiful thing for the seller. But for most owners who have a business attractive to private equity, they should expect a valuation of five to seven times the average EBITDA of the past two years.
Frank and Wanda are going to sell their business, and they will be in fine shape. Though they won’t get an outlier 12X deal, even at the normal range of private equity valuation, they will still be able to play golf in nice places for a long time.
JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. https://www.amazon.com/Home-Pros-Guide-Selling-Business/dp/1599329239 . He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The principles above are true, but the story, names and fact patterns are changed to preserve the parties’ identities.
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