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, having recently returned from a vacation to the home of golf in Scotland.

I met Frank and Wanda 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 Pebble Beach last year.  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! 

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 6-8X EBITDA. If an M&A advisor is making claims about getting more than that, they are tickling the ears of the business owner just to get the engagement or they don’t understand math, and here’s why.

The private equity (PE) model is premised on generating a 3-to-1 return on invested equity within four to six years. 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, these days 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 6 to 8X the weighted average EBITDA of the past three years.

Frank and Wanda are going to sell their business, and they will be in fine shape. Though they likely 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.

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Tennessee Valley Group

Jim is an attorney (non-resident status with the Missouri Bar) and though he no longer practices law, he has read and negotiated enough legal documents to fill a cargo tanker. He has an MBA from Harvard Business School and knows how Wall Street and private equity operates. Jim is a Tennessee Supreme Court Rule 31 listed general civil mediator with tons of experience helping business owners (large and small) work through sensitive problems to achieve winning results. He is the author of "Home Run, A Pro's Guide to Selling Your Business, Seven Principles to Make Your Company Irresistible."

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