What Startup Founders Need To Know About M&A Valuations

As founders near the end of the lifecycle of their startups, the question of "valuation" usually arises in a new context: mergers and acquisitions.

Valuation is no stranger to a founder — it's something they discuss often in rounds of financing as they grow startups. Why then are founders often confounded when they have to assess the penultimate value of their company in a change-of-control sale event?

Ultimately, because of differences in how buyers and investors "value" startups. For investors, valuation is often an art rather than a science, and is frequently based on metrics that are not on the balance sheet.

For buyers — who are acquiring a majority rather than minority position in a startup, there is usually a more scientific way to determine valuation and set a price for the acquisition of a company (different from valuations obtained in financings).

Exit multiples and EBITDA: One path to exit valuation

Mergers and acquisitions (M&A) is a broad term to describe a transaction in which there is a change in the control of a business — either through the acquisition of the business's assets or equity. When a founder reaches this stage of the startup lifecycle and considers possible exits, valuation takes on a new meaning. It represents a potential "pay day" for founders and their investors.

Valuing a company at an exit often depends on the company's earnings before interest, taxes, depreciation and amortization (EBITDA), which represents the company's cash flow.

Using a company's actual financial data provides a baseline for its value. It also accounts for the costs of running a business as a way to measure the company's performance. Buyers and sellers often do a quality of earnings analysis to arrive at an agreed-upon EBITDA for the business, including adjustments to account for unique aspects of how the business operates (or has operated historically).

Buyers will often apply a "multiple" to the company's agreed-upon EBITDA to determine the exit proceeds to be paid to the owners of the business. Exit multiples are calculated with data from recent comparable transactions within the relevant industry.

For instance, if a company's EBITDA as calculated by the buyer is valued at $5 million in the given fiscal year, and the buyer acquires the company for $10 million, the buyer has attributed a 2x multiple to EBITDA for purposes of the acquisition. Companies can take several comparable deals and identify the average exit multiple, then use it to calculate their projected exit valuation based on their EBITDA. For example, Company A may be ready for an exit and have an EBITDA of $1 million. Three similar acquisitions in Company A's industry may have had exit multiples of 8, 10 and 12. Using the industry average exit multiple of 10, Company A's EBITDA multiplied by 10 gives it a potential exit valuation of $10 million.

Factors that contribute to an exit multiple include:

• the overall state of the market
• the industry of the target company
• the strengths (and liabilities) of the target company

Some industries are high-growth and could attract higher exit multiples while low M&A volume in an industry could result in lower multiples. Certain expected windfalls or losses that a company predicts based on customer acquisitions or losses may also influence exit valuation. Calculations like discounted cash flow (DCF) can be applied to predict future revenues at discounted rates and influence the perceived overall value of a company.

Importantly, not all companies have positive EBITDA.

Having positive EBITDA means the company is profitable — and most startups are (famously) striving for profitability during the initial stages of their lifecycles. This is part of the reason why investors often cannot use EBITDA calculations and multiples to arrive at similar valuations for startups for purposes of growth capital transactions.

Why does M&A valuation matter?

Exit valuation is important for founders and investors who are planning to sell a company and trying to predict returns.

M&A valuation differs from growth (or even internal valuations like 409A valuations) in that it looks back at the company's trailing 12 months of performance. Rather than predicting growth, exit valuations look to market comparisons to derive an overall purchase price.

Whereas growth investment dollars are pumped into companies to increase the company's growth trajectory, change-of-control buyers are paying exit proceeds to the owners of the business, so they have to price in the cost of continuing to provide working capital to their acquisition target post-closing. If the company has debt or other liabilities, the buyer may price that into its determined purchase price.

Coming to the table with clear, justifiable numbers based on internal financial data and industry exit multiples is a good practice to prepare for these types of conversations. It helps ensure founder and investor expectations are aligned with those of their potential future buyers.

M&A valuation can also align internal expectations as founders prepare to sell.

Valuations impact proceeds paid to stockholders (i.e. investors and founders) and represent a return on investment, whether the investment was in dollars or in sweat. Aligning stakeholders and setting the expectation of potential M&A valuation ensures an easier deal process once the founders are ready to move on.

Predicting valuation at exit can be difficult, but there are several industry experts that can help founders (even in the early stages) understand what they are building towards.

Depending on the industry, accountants, lawyers and investment bankers can be great resources for getting a sense of market comparisons that are "real" based on the company's recent performance and other metrics. Ensuring that everyone has the right expectations with respect to valuation can help bridge the gap that founders sometimes see between initial valuation and purchase price proceeds. Getting the right advice early can help ensure the juice is worth the squeeze.