Many owner-entrepreneurs develop expectations for their business’ value based on news items and industry chatter about M&A and financing activity. However, the small percentage of transactions that make the headlines are not reflective of the average transaction. The factors we see most often (not in order of frequency or importance) that prevent private mid-market companies from achieving a premium valuation include:
Small Size: Most transactions in the news concern multi-billion companies. While we have seen one in a million start-ups fetch billion dollar valuations, most small companies are discounted to larger companies because of their riskier operating profile and because there is less liquidity in the lower end of the M&A market. Companies valued at less than $10M will not find as much interest as larger companies.
Customer Concentration: The issue of customer concentration varies by industry and by business model. In the automotive sector, if you are a supplier to Ford, GM, Chrysler, VW, Honda and Toyota; six clients, then you are in a good position. Generally, for B2B companies one would like to see at least 20 clients and if your business is a cloud based consumer or SMB focused business than 100 or even a 1000 clients will be seen as small. Ultimately, it is not the total number of customers that is the measure of risk but the exposure to any particular customer. Ideally no customer generates more than 10% of revenues.
Modest Growth Rate: Growth needs to be measured over an appropriate period and in the context of the economy and peers. While a single digit growth is respectable for a mature company, in many sectors it needs to be double digit to warrant a premium valuation.
Principal Goodwill: Principal goodwill is the value of the knowledge and relationships that the Principal holds. Large companies have documented relationships, usually multiple points of contact and formal processes for dealing with change. This reduces risk and improves value.
Lack of Business Model Focus: The challenge with a business pursuing various services and segments at the same time is that it reduces the buyer universe. As an example, take a business that starts out as a IT services/consulting business and then develops a SaaS based service. It gets some traction and now the revenue mix is 60% consulting and 40% recurring SaaS revenues.
We would market this business as having recurring revenues but to pure SaaS companies this would dilute them. Certain consulting businesses won’t have the appetite or capital on hand to invest in the marketing that the SaaS business needs. Lack of focus in the business model will reduce buyer interest and hence value.
So, what does produce a headline grabbing valuation? Simply put, you have to be viewed as being on a path to achieve a leading position in a new segment that is expected to be enormous. Rare, but we do have a number of Canadian technology sector examples including Hootsuite in social media monitoring, D2L in personalized learning solutions, Shopify in online stores and Wattpad, creating a brand new segment, in a community of readers and writers.