How Growth Trajectories Affect Your Exit Valuations
Most acquirers, especially big corporates are looking to “buy” sales growth with a view that this will grow profitability too in the longer term. Simplistically, there are two types from their point of view: standalone and synergistic growth.
A growth story for a business looking to sell needs to be balanced between achievable and ambitious. Often presenting growth plans based on risk is a good idea.
We find Ansoff’s Matrix a good structure for presenting growth plans. For example, selling more existing services/products to existing customers would often be considered lower risk by an acquirer than plans to enter a new geographic market. The lower the perceived risk, the more credible the growth plans and the higher the multiple that could be justified.
When forecasts are perceived as risky, this is when the consideration in a deal can be more weighted to contingent consideration, commonly earn-out targets.
It is difficult for a seller to present growth synergies as it depends, of course, on the acquirer’s own business. However, in competitive sales processes, acquirers may have to consider in their valuation methodologies what sales synergies could be realised from selling the target’s products/services to its customers and vice versa.
The impact of growth on exit valuation and how to measure it
Growth is most commonly defined as the increase in percentage terms from one period to the next, usually, this financial year compared to the preceding financial year. Often compound annual growth rates are calculated to demonstrate underlying annual growth rates over a longer period of time.
Growth in profitability is also shown, although the improvement in the margin (profit divided by sales expressed as a percentage) shows whether the business is a stronger indication if the business is becoming more efficient.
Sometimes valuations may put more weight on the financial forecasts, for example, discounted cash flow calculations to assess the Net Present Value. This is calculated by discounting all projected future transactions to calculate their value in the present. Although this tends to rely on assumptions and projections, it is considered a fairly objective calculation to value a business.
Other growth measures that can be relevant in assessing a company’s valuation are new customer/user growth rates as well as churn rates. These are particularly important when valuing SaaS or subscription-based businesses, or when the buyer is interested in acquiring a company’s particular client portfolio.
Employee count growth can also play a role. If the buyer is interested in acquiring and maintaining your existing talent pool, as well as integrating your existing hiring and HR strategies, then employee count growth can boost your valuation. If instead, the buyer is interested in maximising your margins, they may see a growing workforce as a rising cost centre, negatively impacting your valuation.
The problem with growth rates
There is also one intrinsic mathematical issue when trying to measure growth: according to Seeking Alpha, “the standard way to measure the growth of anything is to divide the present figure by the past figure and subtract one.” Easy, right? Well, this formula works well for sales growth when both the present and past figures are positive, but what about companies that have been loss-making for many years before turning a profit?
Keeping in mind that this is the case for many start-ups, we can see how the above formula to calculate growth “stops working” when negative figures are introduced.
For example, a company that makes £2m in earnings in Y1, £3m in Y2 and £4.5m in Y3 has a decent track record showing their profit grows at a steady 50% rate year-on-year. Not very realistic, but great!
Let’s take a much more common scenario of a company gradually reducing their losses from £4m in Y1 to £2m in Y2, and then finally turning a profit of £0.5m in Y3. Growth rates in this case are all over the place and all negative, not at all reflecting the real upwards trajectory of the company’s profitability.
Investopedia has an interesting article on the alternative measures that can be used to assess growth in these cases, including comparative methods such as valuation multiples.
Beware the “hockey stick” growth rate curve
Proving the future growth of your company—especially in the specific way your buyer needs it—is no easy task.
The due diligence stage of an M&A process will drill deep into the financials to show whether the growth rates that may have been flashed in pitch decks and presentations accurately represent the financial performance of the company historically and whether there are reasonable grounds for assumption with the forecasts.
This is why it’s important to start planning as early as possible, in order to take strategic decisions that maximise the type of growth that matters to your potential buyers.
Once the exit process starts, make sure you spend time preparing adequate financial forecasts and projections that show growth metrics that are relevant to the transactions, relying on solid and proven assumptions…. And crucially stay on your monthly numbers during the M&A process!