Growing Companies: M&A and Capital Considerations

When considering the sale, exit, or capital raising for a growing company, it’s essential to understand the unique challenges and opportunities that come with substantial growth. Traditional valuation methods often fall short when applied to high-growth businesses, so adopting a more dynamic approach is necessary. In my experience, there are several critical elements to consider for achieving optimal valuation during mergers and acquisitions (M&A) or capital raising efforts.

Making the Case of What is There

Understanding Growth Scenarios

Businesses typically fall into one of two scenarios when considering transactions: consistent performance or high growth. Consistent performance might characterize a steady widget manufacturer or software company that has produced similar earnings over the past decade. However, for companies experiencing substantial growth—often 50-100% per year—the traditional methods of valuation based on historical averages can significantly undervalue the business.

Critiquing Traditional Valuation Methods

Traditional valuation methods, like averaging the past three years’ earnings before interest, taxes, depreciation, and amortization (EBITDA), may not adequately capture the true value of a high-growth company. This approach can impair the perceived value by not accounting for the rapid upward trajectory of the business. Instead, it’s crucial to present a narrative that justifies a higher valuation based on recent and projected growth, reflecting the new normal for the business.

Substantiating Growth

To support a higher valuation, it’s essential to substantiate the growth of the company. This involves explaining the reasons behind the growth, differentiating between one-time events and sustainable factors. For instance, if growth is due to a fundamental improvement in the business model rather than a temporary spike, it needs to be clearly articulated. Demonstrating that the growth is sustainable and likely to continue is key.

Demonstrating Permanence of Growth

One of the most important aspects of substantiating growth is proving its permanence. For example, if a company has expanded its sales force from two to five people, resulting in a threefold increase in revenue, this change suggests a permanent improvement. As long as the expanded sales team remains, the revenue growth should be sustainable. It’s crucial to illustrate that the factors contributing to growth are durable and will continue to drive performance.

Illustrating the Future Trajectory

Highlighting Future Growth Potential

Beyond proving that current growth is sustainable, it’s also important to outline future growth potential. This involves identifying opportunities that the business plans to capitalize on in the coming years. Whether it’s entering new markets, launching new products, or leveraging technological advancements, demonstrating a clear path for future expansion strengthens the growth narrative and supports a higher valuation.

Assessing Operating Leverage

Operating leverage refers to the ability of the company’s infrastructure to support continued growth without proportionate increases in operating expenses. A business with high operating leverage can grow its revenues significantly while only marginally increasing its costs. This efficiency can be a strong selling point when presenting the company for M&A or capital raising. By showing that the company’s infrastructure is well-positioned to support further growth, you reinforce the narrative of sustainable and scalable growth.

Valuation Based on Forward-Looking Metrics

Given the limitations of traditional valuation methods, it’s crucial to shift the focus towards current and forward-looking financial metrics. Instead of relying on an average of past performance, use the trailing 12 months’ performance or projections for the current year. In some cases, even future 12-month projections might be appropriate. This approach ensures that the valuation reflects the company’s current and expected growth trajectory, rather than outdated historical figures.

By moving the conversation towards more recent performance metrics, you can better capture the true value of a high-growth company. This not only results in a higher valuation for an exit but also improves the terms and amounts available in capital raising efforts.

Communication & Pragmatism

Practical Implications

For example, when securing financing, the amount of capital provided is often a multiple of EBITDA. By using more recent and forward-looking performance metrics, you can substantiate a higher EBITDA multiple, resulting in increased financing availability. This is particularly important for growing companies, where traditional methods may undervalue the business and limit access to necessary capital.

Communicating the Narrative Effectively

Finally, it’s vital to communicate the narrative effectively. Whether you’re preparing for an exit, seeking investors, or raising capital, the narrative you present must be compelling and well-substantiated. Emphasize the recent growth, explain its sustainability, highlight future opportunities, and demonstrate operational readiness. By doing so, you ensure that the valuation or financing capacity is based on the most relevant and accurate financial metrics.

Conclusion

Growing companies present exceptional opportunities but also require a nuanced approach to valuation and financing. Traditional methods may not capture the true potential of a high-growth business. By focusing on recent and forward-looking performance, substantiating growth, demonstrating its permanence, highlighting future opportunities, and assessing operating leverage, you can achieve a more accurate and higher valuation.

This structured approach ensures that you present a compelling narrative to potential buyers or investors, maximizing the value of your business. Embrace these strategies, and you’ll be well-positioned to navigate the complexities of M&A and capital