For small and mid-cap companies that are still in growth mode, the question can be complex.  During the early stages of corporate growth, business owners are focused on launching and refining their products, increasing domain and market knowledge, and establishing sales and marketing channels.  For the most part, cash from operations is being reinvested in building the business—and debt and equity financing is being used to supplement this development.

Companies at this stage have usually not focused on achieving profitability or maximizing cash flow from operations.  Instead, the emphasis has been (and rightly so) on constant reinvestment to build enterprise value—the kind of value that will be fully realized down the road.

When determining the value of a company, there are a wide variety of methodologies typically used.

Generally speaking, those methodologies can be divided into two types:

• Valuation based on financial multiples, typically of revenue or EBITDA, and

• Valuation based on non-financial items, which may be some combination of the potential value in the business and the strategic value to a particular class of purchasers.

Financial multiples are particularly useful in valuing a mature business with a long history of revenues and profitability.  In those cases, the annual growth rate is often in the low single digits.  Companies like this have stable, repeatable growth that can be used as a foundation for valuation.  Much of the riskier investment has already been done: the products are mature, market acceptance and brand awareness have been established, and the sales and marketing plan and distribution strategy is clearly understood.

The value to a buyer in these types of acquisitions is two-fold.  Firstly, the buyer knows what they are getting and should be able to forecast out at least a minimum level of ongoing revenues and profitability based on the target’s past performance.  Secondly, the buyer often has the ability to expand sales and improve margins by economies of scale, and thus reap the benefits of increased cash flow.  In these cases, financial multiples are a very good measure of the value of the target.  The buyer can usually model out with some degree of accuracy its return on the investment at a particular acquisition price.

Determining the Unlocked & Strategic Potential

However, for a smaller company that is in high growth mode—from 15% to 30% annually and more—financial multiples based on historical revenues and cash flow is not the true measure of the value of the business.

Small to medium sized companies at this stage are expense-heavy as compared to their revenue run rate.  The company will still be investing heavily in ongoing R&D, will still be building out its sales and marketing channels, and will still be too small to realize economies of scale across all expense line items.  Margins will be skinnier and often the companies will not yet be posting positive EBITDA of any measurable amount, if at all.

This investment in the company, however, is what sets the company up for future growth.  While there is obviously still execution risk, it is fair to say that if the company has a compelling product to offer and the market is large, revenues will ramp and profits will come and with it positive cash flow.  The true value in the company at this stage is not represented by its current financial performance.

The key factors in getting to a more accurate valuation for these kinds of companies lies in determining both their unlocked value as well as their strategic potential.

To a buyer with greater human and capital resources, larger sales and marketing organizations, more mature distribution channels and other operational scale, the ability to monetize on this potential is much more likely.  The value to a buyer in this situation is not only the ability to improve margins, but also the ability to scale the business dramatically.   A valuation conducted on a revenue multiple at this stage only captures a small part of the value of the target, and a valuation based on an EBITDA multiple is misleading as it actually punishes the company for the heavy investment being made in the business.  Investment which is going to drive future value.

Understanding the potential value locked up in the company and its strategic value to a potential buyer is key to maximizing the sale price.  This is a much more difficult task than building a valuation on financial multiples, and requires a very different skill set from your advisors.