Four valuations of one company. Each answered a different question

Sixty, eighty-four, one hundred and two and one hundred and forty-four million zlotys. One company and one quarter, yet the highest of the four valuations is almost two and a half times the lowest.

It is easy to take such a spread as proof that business valuation is an arbitrary art. In my view there is more precision in it than in a single number. Each of these figures is an exact answer to a different question, and the spread stops looking random once you know who was asking what.

Two offers, of PLN 60 million and PLN 144 million, came from strategic investors. A private equity fund proposed PLN 102 million. PLN 84 million is the valuation at which the company would have gone public. The fourth type of investor, a venture capital fund, as a rule does not invest in companies this mature and made no offer.

All four amounts represent the value of the whole company before deducting its debt. The fund’s offer and the stock market valuation imply that the company generated about PLN 12 million of EBITDA, that is annual operating profit plus depreciation and amortization. The valuations therefore ranged from five to twelve times annual EBITDA. I have changed the details so that neither the company nor the parties can be identified.

Each of these figures also has another side, which often gets pushed into the background in price negotiations. The amount says how much the owner will receive. The type of investor determines what will remain of the company, and of the role of its current head, after the deal.

Venture capital asks about exceptional growth

A venture capital fund makes its money on the few portfolio companies that grow their business more than tenfold within a few years. From the rest it expects at least the return of the money invested. Such a distribution of returns is called a power law. A company that grows by 20 percent a year, makes a profit and has predictable results is an excellent business for its owner. With a venture capital fund it is ruled out at the start, just like a pitch in which everything is predictable and free of risk.

Even if such a fund did invest, the money from the round would go into the company, so the owner would receive no cash in hand. His stake would be diluted, and within five to eight years the company would have to be sold or listed on the stock exchange. Venture capital is chosen by an owner who wants fast growth and commits to delivering it to someone who has the right to demand it.

A private equity fund asks about debt

Here the logic is reversed.

A private equity fund values cash flows and the exit route. It wants to know how recurring EBITDA is, how much debt the company can carry and to whom the fund will sell the company in four or five years. I wrote in July about how much debt a company can carry. A bank will lend up to about two times EBITDA. Private debt, meaning loans from debt funds, together with mezzanine financing can raise total debt to about 4.5 times EBITDA, but only in the most predictable companies. Mezzanine financing is the most expensive, because it is repaid only after the bank loan.

This level sets the upper limit of the fund’s offer. The more debt the company can carry, the less of its own money the fund has to put in and the higher the price it can offer for the same expected return. The offer of PLN 102 million, or 8.5 times EBITDA, came from this calculation. If the buyout were financed with debt of 4.5 times EBITDA, or PLN 54 million, the remaining PLN 48 million would be covered by the fund’s money and the value of the shares the owner keeps in the company. This new debt is taken on to buy the company, but it is then repaid by the company itself out of its profits. What reaches the seller’s account is the value of the whole company minus its existing debt plus the cash it holds.

A private equity fund is chosen by an owner who wants to cash in most of what he has built and still run the company. In the buyout he sells most of his shares, keeps a minority stake and runs the company for the next few years. When the fund exits, the owner sells the rest, often at a valuation clearly higher than the first time. In successful deals this minority stake is sometimes worth more at the fund’s exit than the whole company was on the day of the first sale.

The company carries on under its own name and with the same customers. It also gets what it would not have built for itself: management reporting and a supervisory board that asks awkward questions and keeps an eye on the budget. This benefit has two costs. The fund has a set exit date, usually after about five years. After those five years a new owner chosen by the fund will arrive, and the shareholders’ agreement usually obliges the owner to sell his shares together with the fund.

A strategic investor asks about the difference

The two strategic offers differed by PLN 84 million. Both buyers operated in the same industry, saw the same financial statements and talked to the same management team.

The strategic buyer is the only one in this comparison who calculates something other than the value of the company itself. He calculates what his own business will be worth after the acquired company is folded in, and subtracts the value of his business in its current shape. This difference is called synergy. The first buyer already ran exactly the same business as the company for sale. For him the difference was almost zero, so he offered what it would cost to rebuild the assets and the team, and not a zloty more. That came to PLN 60 million, or five times EBITDA, less than the fund offered.

The second buyer did not have this capability. Building it from scratch would have taken him four years, and in that time the market would have closed. His offer, PLN 144 million, or 12 times EBITDA, was the price of cutting those four years to zero.

The PLN 60 million offer left out one amount. The first buyer did not calculate how much he would lose if his competitor acquired the company and used it to shorten its path to the market by four years. Showing him that amount is also part of the seller’s job.

The seller’s job, then, is above all finding the second buyer. This is the part of the process I described in the article on what a transaction adviser is paid for. For each group of buyers the investment thesis, meaning the reason the acquisition should pay off for them, sounds different. A document sent to ten random companies in the industry answers the question of the buyer who already has the capability. At Capital One Advisers we select the recipients before the first phone call. Once everyone has received the same information memorandum, the document describing the company, it is no longer possible to present the company to each buyer in the light of his own needs.

For the owner, however, this is the choice that changes the most. The same synergy that justifies the highest price means integration. The buyer will close duplicated departments, because that is where part of the promised value comes from. The brand is phased out more often than owners assume. Customers who chose this company as an independent alternative end up with a competitor they had deliberately avoided. The owner sells all his shares and leaves after a transition period, because there is no lasting role for him in the buyer’s structure.

A strategic buyer who needs the company pays the most and changes the most in it. The high price and deep integration have the same source.

The stock exchange asks for a comparison

A stock exchange listing differs from the other three routes in how the price is set. In a private transaction the price results from one buyer’s analysis and from negotiation. In a public offering it is set through bookbuilding. The brokerage house running the offering collects declarations from institutional investors on how many shares they will buy and at what price. It then checks how many shares the institutions want to buy at each price level. The price is set where demand covers the whole offering and gives the company a stable shareholder base.

Institutions value a newcomer against similar companies already listed, so a well-chosen peer group matters most. The company’s equity story has to be simple, because a business model that takes forty-five minutes to explain cannot be sold during a two-week bookbuilding.

The price also comes out below the multiples of listed companies. Institutions expect a discount for the risk of a debut, and the company wants full subscription and a rising share price in the first sessions. For a company of this size, the block of shares in the offering is small, so there is also concern about low liquidity after the debut, and the discount grows. Hence a valuation of seven times EBITDA, while similar listed companies were valued at 8.5 times EBITDA. The discount was therefore about 18 percent.

Of the routes open to this company, only the stock exchange lets the owner keep a majority stake and control. The company carries on under its own name and with the same management, and the owner continues to run it. The supervisory board and the minority shareholders hold him to account for that. He pays for this with a valuation lower than the offers from the fund and the second strategic buyer. For a set period after the debut he cannot sell shares. Investors who buy shares in the offering require such a lock-up. The company bears the costs of being listed, and the management board works under the pressure of quarterly results, which can distort long-term decisions.

Comparing the strategic buyer with bookbuilding leads to a conclusion that sounds contradictory but follows from two different mechanisms. A strategic buyer pays a premium because there are no similar companies on the market. He cannot buy this anywhere else, and he knows it. In bookbuilding the same feature works the other way. The institution has nothing to compare the company with, and what it cannot compare, it values more cautiously.

The owner of a truly unique company therefore has the best chances with a strategic buyer. The owner of a solid company that is easy to compare, boring in the good sense of the word, is in a better position on the stock exchange and with private equity funds than he thinks.

The price and what remains of the company

Three of the four valuations, arranged from lowest to highest, also show that the higher the price, the less remains of the company as it was. The stock exchange at PLN 84 million leaves the company almost untouched. The fund at PLN 102 million takes control, but the company carries on under its own name, with the same team and customers, and the owner can stay. The strategic buyer at PLN 144 million pays the most and absorbs the company into its own structure.

The fourth figure falls outside this order. The first strategic buyer offered the least, and since he already runs the same business, he would absorb the acquired company. Such an offer combines a low price with full integration. Venture capital pays the owner no money at all, yet demands a pace of growth he would not have chosen himself.

This order has exceptions. Some strategic buyers leave acquired companies independent for years, because they see value precisely in their separateness. A private equity fund that buys a company as an add-on to another business in its portfolio will integrate it just as a strategic buyer would. There are also funds that cut costs so hard that they leave the company weaker than they found it. Still, the direction is consistent enough to treat it as a starting point and to check the exceptions separately.

Each route requires different preparation

Preparing the company for one route weakens its position on the others. A private equity fund wants to see recurring earnings, cleaned of one-off events. The same work makes the company uninteresting to venture capital. With a strategic buyer in mind, one builds a unique market position, which then makes valuation in bookbuilding harder. A company that makes itself resemble its listed competitors ahead of a listing loses part of the premium a strategic buyer would have paid.

The direction of the sale is therefore decided two or three years before the deal. Most often this happens through everyday management decisions, and the owner sees their effect only when the offers arrive. At Capital One Advisers we set this direction with the owner several years before the sale and prepare the company accordingly. The adviser’s fee is a fraction of the difference between such offers.

Before choosing a route, the owner should assess whether the company can grow more than tenfold, whether its cash flows can carry buyout debt, and whether similar companies are listed on the stock exchange. The most depends on one sentence: what a specific strategic buyer will get from the company that he cannot build himself in four years. An owner who cannot write that sentence will get an offer closer to PLN 60 million than to PLN 144 million.

More important than these conditions is the answer to the question of what should remain of the company in five years and what difference in price the owner is willing to pay for it. When the answer is “nothing, I want to sell everything and leave,” the highest offer is simply the best and there is no dilemma. With any other answer, the amount in the agreement alone is not enough to make the decision.

What independence costs

The difference between the stock market valuation of PLN 84 million and the second strategic buyer’s offer of PLN 144 million is the amount the market set for the company’s name, team and independence. It comes to PLN 60 million, by coincidence the same as the lowest offer, and equals five times the company’s annual EBITDA. With a listing the owner does not receive PLN 84 million in cash. He keeps most of the shares in a company valued at that amount and sells only some of them in the offering.

For many sellers, such a premium settles the choice in favor of the highest offer. An owner who wants to keep running the company and keep the team may, however, decide that five times annual EBITDA is too low a price for giving up a business built over many years.

Service: M&A advisory on a company sale