What’s Really Behind a Valuation?

Is there a cheat code for buying or selling a business? A simple way to know that the price you’re paying (or selling for) is a fair one? In theory, it may seem simple: take the money flowing in or out of a business, qualified with a few variables like the potential for future growth, and voila, you have your price tag.

But, that’s really just a starting point. The truth is that there is an entire professional class whose job it is to understand how the nuances of a particular business — not just its revenues or potential for growth, but the myriad factors that influence these — affect its value.

Christopher Creatura is the owner of Conway Merchants, an integrated merchant bank providing M&A advisory. For the last 10 years he has worked on mergers and acquisitions worth tens of millions of dollars at Deloitte, and then upwards of hundreds of millions of dollars during his time at Merrill Lynch.

But even for businesses operating on this scale, Creatura says that the stage of the business matters more for arriving at a valuation than the size.

A business that is generating a lot of profit is going to be valued according to that profit (“a steady state” business), whereas a business that is growing is going to be valued on its (potential) growth (“a growing state” business). A startup’s valuation is a little different in the sense that the buyer (or investor) is casting a multi-layered bet — not only that the business will generate sales but also that it will be able to capture the value of those sales as profit. Being able to accomplish the former does not guarantee the latter.

The type of business also matters. For example, software-based businesses have very low, or in some cases zero, incremental costs. They build a product once and can sell it, theoretically, infinitely to different people. SaaS (Software as a Service) businesses, Creatura explains, are a further step in that direction where you are continuing to sell the same product (or service) to the same people on an annual, monthly, or weekly basis.

For that reason, recurring revenue is the relevant metric in the valuation of SaaS businesses, and the growth potential often plays a much greater role in valuations of software businesses generally.

Baked into all this is a level of risk. It costs money to run a business. During the startup or growth stage, or as is sometimes the case, the transition phase following the sale of a small business, many businesses run out of money before they can turn a profit. With small businesses, these risks often have greater bearing on the valuation.

For example, as we have written in previous blogs, one of the red flags you’ll want to look out for as a buyer is when a business seems to rely very heavily or even solely on one person (like the owner) or on a very small number of customers. But even when this isn’t the case — even when there are solid processes in place that ensure the business runs smoothly regardless of who’s running it— you may lose clients who were loyal to the former owner rather than the business itself.

There are steps you can take as a buyer to mitigate these risks, and likewise there are things you can do as a seller to put potential buyers at ease. Creative ways of structuring the deal can ensure the seller has a stake in the future success of their business, for example.

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Opinions expressed here by contributors are their own.

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