Private Equity Experience

Cracking the Code on Private Equity Valuations: Understanding the Art and Science of M&A Deals

• Emily Sander • Season 1 • Episode 9

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This episode of The Private Equity Experience dives deep into the crucial and often dramatic world of business valuation in private equity deals.  Hosts Emily Sander, Rory Liebhart, and Ed Barton explore the complexities, emotions, and strategic considerations determining a company's worth during the "buy phase." They discuss key valuation methodologies (revenue multiples and EBITDA multiples), the importance of revenue recognition, and how "corporate hygiene" (organized and accurate financial records) directly impacts perceived risk and, ultimately, the final valuation.  The hosts emphasize that getting the valuation right is paramount, as it sets the tone for the entire private equity hold period and impacts the relationship between the seller and the PE firm. They use the analogy of selling a house to show how expectations and values can differ. The episode explains the importance of understanding your audience in pitches.


Timestamps:

00:00 Introduction: The High-Stakes Deal
00:16 Structuring the Deal: Key Considerations
00:41 Valuation Methodologies and Emotional Factors
02:33 Real Estate Analogy: Setting Expectations
03:34 Investment Bankers: Bridging Perception and Reality
04:50 Revenue Recognition: A Critical Component
07:27 EBITDA Explained: Understanding the Basics
08:34 Adjusted EBITDA: The Art of Creativity
14:43 Choosing the Right Investment Banker
21:45 Corporate Hygiene: Preparing for Valuation
26:27 The Importance of Accurate Valuation
28:43 Conclusion: Setting the Table Right

Who We Are

If we haven’t met before—Hi! We’re a team of professionals who’ve worked together at multiple companies, seen private equity from all sides, and are here to share what we’ve learned to help you succeed. Ed Barton brings decades of tax and financial strategy experience; Rory Liebhart is a finance and M&A pro with a track record of high-growth exits; and Emily Sander is a former Chief of Staff, multi-time author, podcast host, and founder of Next Level Coaching, helping leaders and organizations accelerate their growth.


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Emily:

Imagine this. You have built a company from scratch, and you have put your blood, blood, sweat and tears into this thing, and you have a potential buyer at the table, but the stakes are super high, and this could be a life changing event. How do you structure this deal? What types of things do you need to consider, such as valuation, methodologies, post transition pieces, all of that good stuff? So we're going to dive into this in this episode, and We have some stories. Some of them are good. of them are different. But, uh, we've, we've seen this from, from multiple perspectives.

Ed:

And I think even more than the art and science, there's a lot of emotion that people claim as art and science in the, in the, in the, both the diligence and the valuation phase of the, of the business.

Emily:

Well, I think if people go in and like, are trying to do like fine tune brush strokes with like paint within the lines, they end up doing like abstract art where they just spew the. Paint can across the canvas and because they get into it, it's like their baby and they get so tied up

Ed:

Well, and it depends. I mean, I think Rory and I probably could use it, you know, kind of stretching that analogy. There's been some that have been like crayons. I mean, it's, it's not even paint. It's not brushstrokes. It's, it's fricking crayons. And I've, I've, Interestingly, those are largely the ones where I've been called in to turn them around because I look at the valuation. How did you get there? And you know the the PE guys tend to get and they've been all guys by the way. I have yet to find a Roy and I have worked with a couple women in PE and they they've tended to be less Um, a motive on their, on their approach to things and they, and probably more effective candidly. Um, but the, all, all the guys have been like, Oh no, there's this great opportunity. And it's, and a lot of it's pie in the sky, you know, total addressable market, Tam, you'll hear that. Uh, yeah, it's spreadsheet stuff and the reality just doesn't match. And I'm like, how did you get to like 32 X EBITDA for this business?

Emily:

a private equity deal, like a deal is like where spreadsheets meet like a soap opera TV reality show drama.

Ed:

This is honest to God truth. that's a, that's the best way I've ever heard it described. Yep. so founders will ask you like, so what's my company worth? They have a number in their mind already. It's like, it's like somebody going to the real estate agent. We use this analogy in the book and I use it a lot because each one of these businesses is unique, just like a piece of real estate. When you go to sell your house, You, you've done the comps, you've looked on Zillow, you're like, I know that this house is worth, is worth 800, 000. And then you go to the real estate agent, they're going to give you a range, and if that range doesn't meet your expectation, you're likely to find a real estate agent where that range does meet your expectation. And that, and part of this role is the investment bankers are supposed to help you with valuation value, setting the expectation as part of their job, but they don't get to do that part unless they get the engagement. And so there's, there is sometimes the You know, when they're talking to you about the engagement, they'll go, well, just like a real estate agent. Well, well, I think this is a unique, unique business and it's worth block. And then they get in there and they go through that. And we've talked about this a few times that preliminary diligence and are helping you set up the data room and they're looking at all this stuff. They go, well, you know, we, we were identifying some issues and they may reset you. Um, but the investment banker's job is to bridge the. The perception and the reality part of it, I guess, investment bankers have a tough job. Um, but one of their jobs is to bridge the perception of reality to expectation on valuation and help get that deal across the finish line by getting the price up on the buy side and getting the price down and expectation effectively set on the sell side. the other part is, what's the quality of that revenue. And one of the key components is the ability to, um, not only predict, predict that revenue, but also recognize that revenue properly. And a lot of the businesses that we've been associated with. Um, you know, and I'm, and I'm thinking all, I'm thinking like in Rory's case, the, the businesses that were, um, specialty finance related. So like the B lines of the world, um, and the, the business that we worked in together at the fusion zone, we all had issues around revenue recognition. So you had deferred revenue issues. You had, you know, when was the revenue recognized, how much, how much in each period. And so those become. Um, areas where during diligence, if your, if your business is generally valued on a multiple of earning or a multiple of revenue, those revenue recognition policies are going to come under intense scrutiny, um, cause it's really driving the business valuation and you're going to want to have some of those elements dealt with, with your accounting team before you you know, before, before you go to market so that a lot of those issues end up resolved.

Emily:

Yeah. So let me, okay. So we've talked about a lot here. So there's revenue, so there's revenue and EBITDA, there's the two big valuation methodologies just like to keep it simple, like big buckets within revenue, which seems relatively straightforward, which is like, take your revenue amount and say, okay, what are people in your industry? In a similar category projecting or, or doing, um, and there's lots of nuance in there. So recurring revenue, I remember when we worked together at a company we worked at G2, I was in charge of the client management team and you both told me, Emily, have your team members people. Extended or renewed on these on these certain types of contracts, which were like legitimate contract. They were just for a longer term, but we would kind of give in certain places because we wanted the longer term contracts. And now and you were explaining it to me. But now I know, you know, having. Had my career now. I understand like, Oh yes, because we wanted to be able to say predictably we have this amount of revenue under contract when we were going out for deals. And so that there was, that was just for my department, my client management department. There were other things we were doing across the company with sales and operations and everything like that, but that's an example of the nuance. And the other thing you mentioned, Ed, which I think just giving these examples is good. So people can hear about the different kinds of things we're talking about is let's just say that we are both aware of an occurrence where revenue was. Was counted in two places, meaning there were a couple of different areas of the business and subsidiaries and different entities within an umbrella business. And revenue from a product line was counted in two places. And that was, that was, uh, somehow missed and later found out, and that was a problem. So revenue recognition and how you calculate things and structure things, um, is absolutely under. Scrutiny in that first revenue category. And then for the second bucket, which is EBITDA, let me just break this down to make sure that I get it. And our listeners get it. Um, earnings before interest tax taxes, depreciation, amortization, which is basically like a fancy way of just removing all of those big, like long term things like, uh, Make like debt like loans and long term amortization for like equipment for like 20 year long type things where you're taking a little bit, uh, year over year for 20 years. If you have like, I don't know, a tractor or something or certain computer equipment has has these calculations you do. So you're removing all of those types of things and talking about cash flow and operating cash flow. And then you're doing the similar process, right? So you're saying, okay, for companies in my industry, similar, similar to, um, the type of company we are, here's the type of deals that they're doing. And here's the type of EBITDA projections. they're making. Is that, is that what we've said here in our examples?

Ed:

Yeah, that's, that's, that's basically correct. Your, your EBITDA is one element, but you normally have what, and you kind of alluded to it, adjusted EBITDA. So you've got EBITDA, which is Earnings Before Interest, Taxes, Depreciation, Amortization. Those are straightforward add backs. And then people like to

Emily:

is where you can get creative. Creative. You can get artistic.

Ed:

Yes, that's, that's, that's could be Pablo Picasso right there.

Emily:

You can be Picasso. You can finger paint. You can do interpretive dance,

Ed:

Jackson Pollock is probably closer to what I've seen in most of the, most of what I've worked with. But yeah, it's, and the intention. I mean, again, this is a, it's, it's not a secret, but the intention is most everybody goes, you get these one time things. So you want to take all the one time good things and say that they're going to keep happening. You want to take all the one time bad things, or even some of the things that happen once in a while, and say that they're one time, and you put those into your adjustments column. So you adjust your revenue up, you adjust your, your, um, expenses down, and then everybody will look at that. And most of the time, discount the one times. The, the sellers, the, the, the founders will tend to pound on the table and go, you know, this is absolutely one time and it's never going to happen again. And, you know, it was a tax, it was a tax event or whatever. But that, that's where a lot of creativity comes in on adjusted EBITDA.

Emily:

but here's like an interesting part. So all of these are relative to peers in your Industry.

Ed:

Mm hmm.

Emily:

And so I think a lot of people get confused on like the absolute value, like the number, which I mean, like, I'm trying to think of an example, like maybe when you're looking at like stocks or ETFs or something where like there's certain ratios that you look at on the technical side, we're like, okay, that's the number, but it means nothing unless you have it in context

Ed:

Right.

Emily:

its category. So like relative to what, so I think it's important to. Consider that like that's always going to be involved or included at some level in the valuation process.

Ed:

Yeah. And, and the other, the other piece to keep in mind is valuation headline number is not necessarily real valuation. So a lot of times you'll get, and I, I know we talked about this in the book. I think we've talked about this on these, on these pods too, where you're like, well, you know, they might say they're offering you a hundred million. And, you know, when you're getting your indication of interest in to gate folks to the next round or even choose your final diligence partner to kind of go through process with. When you look at the actual deal structure, it might be 75 million or 65 million in cash and then an earn out and then a, you know, a bunch of contingent payments or contingent, um, a basket for, um, liabilities. And so the entire deal structure needs to really be analyzed to figure out what the true economics are. Because you could say, well, I'm going to give you, you know, 10x EBITDA, which is, you know, So two turns or two more times, eight, eight X versus 10 X would be two turns, two turns more than any of the other, any other components. But then you end up with, you know, some onerous deal terms in there that make it almost apples to apples. It's just, you know, when you start setting them apples to apples and showing your cash flows and your present values and all those things, it's, and that again, is something that both the internal team, so the CEO, CFO, As well as outside counsel, outside advisors and investment bankers need to kind of show apples to apples on the term sheets or force everybody into a equivalent term sheet in order to be able to evaluate.

Emily:

and so if you're, if we're talking to like a founder, like my general approach is get evaluation you think is accurate and fair. And then also there's like the personal piece, which is like, what does this deal need to look like for you personally? And if you've got those two big rocks, then you're probably going in the right direction. Would you add?

Ed:

yeah. And again, we've mentioned this numerous times, know what you want when you go into the transaction, why are you going in? And if it's like, no, I'm trying to get some money off the table, try to diversify my holdings, but I still want to work for another seven years. And I've, you know, really looking forward to the bite of the apple, et cetera. Optimizing your purchase price may not be. May not be the right answer. Maybe, hey, can I, can I work with these folks for the long haul because that's my goal to build value in this business and, you know, get enough off the table to make it, make it worthwhile. You go with the, I'm getting the highest headline price, or I'm trying to optimize my income today. You may end up, if you can't work with those folks, it's not going to work. You're going to end up out. This is not as if they've got control. You're not you're not gonna be happy and you're gonna be wishing that you had Taken the lesser deal with the folks that you you jive with Mm hmm

Emily:

myself and I'm just going to exit this and that's my plan. So if that's your plan, then it's like, okay. And we've, I, you know, we've run into founders who like say they care about their teams and do that whole talk track. And in reality, they're out for themselves. And so, know, that, that scenario does exist where it's like literally how big can I make my personal number? I don't really care what leadership is in place afterward. Um, I'm going to get mine. And so like you have all these different equations or different, uh, of intended outcomes that you're looking for. So know that, and we have talked about that in the past. How do you know if you're getting an accurate and fair valuation? If you're like, this is my first rodeo, like I have an investment banker, I think this seems right, like gut check wise, but I'm kind of basing this on, you know, not a lot of foundation here. What's the best way for someone

Ed:

You need to have done your homework going into it And once you've, looked at what the comps are and you've talked to multiple investment bankers and gotten them to give you feedback as to what your company's worth. And again, the other thing that we've said over and over again is that choosing your set of advisors, your investment bankers, your accountants, your attorneys, that's not, it should not be a one and done process. That should be a little bit of a little bit of a beauty contest, some interviews, ask those kinds of questions, get some, you'll get some consensus around what the valuation is. And if you're off that valuation, you should understand why. high or low, um, going into that transaction. And so that's your, the best way to know it's a good deal or a fair deal on a valuation side is to have really set those expectations or have gotten, you know, a set of expectations from various sources and then be able to triangulate that against the term sheets you're trying to evaluate. Um,

Emily:

or three investment banks, or would you suggest an investment bank and other entities that would provide evaluation?

Ed:

so when you're going through choosing who your investment banker is going to be, that's one of the questions you should be asking is, what do you think the company is worth? How would you go about coming up with a valuation? What are the key drivers to valuation? And are there anything, or is there anything we should be doing now, between now and when we go to market, or between now and when you buy? when you, uh, when we get into negotiations that would help us improve our valuation or improve the perception of the business to potential buyers. That's so you'll choose one investment banker. Once you've chosen an investment banker, you're basically mated for the purpose of that, um, for the purpose of that transaction. So you're not. I mean, you can go out and get and pay for, and you're going to pay for, um, additional valuation, uh, information if you want to have a business valuation expert or somebody like that come in and validate your offer, um, and that's an option, especially if you feel like it's, if you just aren't feeling right, there are folks who specialize in business valuation, um, CPAs and others that Um, a lot of times for estates or, or tax issues so that that way with, with audits, um, to set values. Um, so that's something you can do to, to check it, but in, in general, you should have a good idea and do that prior to going to market.

Emily:

So, so do your research is a, is a huge one. And then in the investment bank vetting process, you ask them these types of questions about their approach to valuation and kind of what they see. And then you choose an investment bank. Now, just to be clear, are we, are you saying spend the money? With two or three to get like an actual

Ed:

No. So, so yeah, you just ask him. It's kind of like choosing a real estate agent. So they're, they're normally an investment banker. They may have some retainers. So some portion that's, you know, pay to play. Um, but most of them, they make their money on a percentage of the sale price and the higher the sale price and more they make just like a real estate agent does. So during that interviewing process, they're going to want to. Get that business, and that's the time to ask a bunch of those questions.

Emily:

How would, so as part of that vetting process, do they give you like a rough estimate of like how they would value the company? So you have like three numbers to compare.

Ed:

And you should be asking that question, and asking what the drivers are, and asking how they came to that

Emily:

So they might not be able to like the deep, deep, deep dive until they get in, but everyone in that phase of things should be able to give you a estimate. If you're like, okay, like whatever, uh, three or like four out of five. Are in this general range and this one's kind of known for being aggressive or whatever a creative Um, that might be one thing if you're like whole like i'm getting like five different answers here or you know Best out of three type of thing. That's a

Ed:

I don't have an IB pitch book here, I don't think, and even if I did, I probably shouldn't share it, but I, a lot of times when I've had an IB's pitch, they actually will give like a sheet of here's Like the last, in the last 24 months, here's all the companies that are close to comp that have transacted. Here's the seller, here's the buyer, here's the valuation, here's the almost like you would get, again, in real estate, here's all your comps, and this is how we're coming up with how, how we would, we think your company's going to be valued. So they'll have done, they, there's companies like PitchBook that track all these, uh, transactions, and then the investment bankers, PE guys, all the, all these folks that, Rely on this information, pull that information out, and it's available for your use. And if you get three investment bankers, I'll put, I'll put, you know, a buck on the fact that 80% or 90% of the deals that they show you on the comps are going to be laid out that way. And they're gonna be the same deals with the same calculations and same multiples revenue, EBITDA multiples.

Emily:

so it seems like you know this If we zoom out, this overall trend of having public information on things like Zillow and Kelly Blue Book and PitchBook, you can do a lot of this research yourself now, which is great. Still need kind of a specialist once you get into fine tuning and get serious about things, but there, there is that information out there that people should be looking at.

Ed:

Yeah, and, and the other, the other part, um, is there the, the underlying components of like how fast are you growing and, and, or how fast were they growing and what are the other, you know, kind of subjective or even mathematical and growth in the case of growth, discount rate, interest rate at the time of which those transacted are all going to be. Inputs into how they are valued. So don't take any of that as gospel. It's broad range But it should give you an idea and you should be able to triangulate a bunch of those things into a yeah My company should be worth somewhere in here And if you're going through the process and you start falling outside of those ranges upper or lower You should be asking yourself Why don't just get excited because you're falling out you're falling into the upper side of the range Understand why you're falling into the upper side of the range Cause it may be an expectation that's that you're setting or that especially if you intend to remain that you're setting that you're not going to be able to hit if you're showing, you know, quick growth that, you know, is going to plateau you. That might be a good reason to sell the business. It might not be a good reason to stay in the business. If you know that you're going to hit a plateau and you know, folks are buying on a, no, that's going to continue to infinity type of type of thesis.

Emily:

Okay. So we've covered a lot of ground here. We've talked about, um, revenue valuation methods, EBITDA valuation methods, know your why and know what you personally want to get out of this. We've talked about investment banks and getting a couple different perspectives there. Um, is there any other? And you've talked about the market conditions. We're like, hey, interest rates and things like that. Are there any other major considerations where it's like, okay, if someone's about to go into this part of the process for real, make sure they've got their ducks in the row over here.

Ed:

Yeah, I'll, I'll touch on it. And Rory has used the. term corporate hygiene, which I think is a little skeevy. Um, but

Emily:

It means take a shower in

Ed:

yeah, but the, the reality of it is a cleaner, your books and records are the better presented. Your models are the better organized your, your, um, The more your team has rehearsed the meeting so that they riff off each other well, that all goes into valuation. Those are all the subjective pieces. And yeah, I teach finance, um, at local universities. So I, I, you know, a lot of it is math and Rory talked about the math, but the key on, on even on the math for the math nerds, the, the, you've got a risk free rate and a risk premium. Yeah. And so you, the sum of those two is what you discount your expected future cash flows at. And you know, Rory kind of hit on that with the EBITDA piece. That risk premium comes down if there's a perception that this is a less risky trade because all this stuff seems really wired tight. And so I'm, there's less unknowns and less unknown, unknowns, known unknowns and unknown unknowns. It's my friend Don Rumsel would say. And so when your discount rate comes down, your valuation goes up. And so as a result, going into this, Make sure you've got your books, records, virtual data room, pitch, all that stuff down cold and it looks right and it, and it is right so that you don't raise risk flags, which will then drive the risk premium up and then drive your valuation down. Yeah. Hmm.

Emily:

For people to come look at it. Cause if you just have an empty room, it's like, okay, like the math works out that it, uh, but this is just like a bare, empty, gross room. Whereas if you're like, Oh, like the sofa could go here and here's the fireplace and here's how you could make it look, uh, interior, uh, decorations. And it was funny. I had a. a coaching client who was a founder, original founder and CEO of a successful business going out for their next round of funding. And he was like a nerd through and through, just like a technical nerd who could code, who was a genius. Um, and yes, he was from India. So he just like hit all the stereotypes and everything. And he, um, was having trouble. Giving his pitches to investors because he was just such a technical nerd. And so, uh, we worked on a couple of different things, but one, one is like speaking at a level that your audience is going to understand. So having that like polish, but also understanding where your audience is coming from and that fine balance between delivering information that is relevant and helpful to them. That's at their level without being condescending. So kind of threading that needle. But he was such a nerd that you couldn't get over the fact that he like, Oh my gosh, like this is not what we call a people person. He just would nerd out on things. So we made a joke. So I said, okay, open it like this. Like open it like, hello, um, I'm from so and so company and my name is, and he had this, this Indian name, short first name and super long last name. And he would kind of say it and stutter and say, I hope I said that right and just get a little laugh out of people. then, and then he would literally say like, I am a, I'm a tech nerd, but I'm going to try to be around people now. And so everyone kind of knew, okay, here's what I'm getting into, but just for him in that setting that worked for him to be able to connect with people, but whatever your situation is, find what's going to work for you and your team. in these settings. A lot of founders are like the opposite, right? They're like the flashy, kind of gregarious, like, hey, I could talk to, you know, dry, you know, dry paint on a wall and I could carry on a conversation with the Chia pet type of thing. So, um, sometimes it's the opposite problem, but I would, I would definitely agree. Just make yourself prepared and make it so it's polished for, uh, for your audience. All right. Final call for valuation methodologies and going into this. Dramatic spreadsheet, TV soap opera deal.

Ed:

Um, you know, I, I know poor lead parts having technical difficulties, which is

Emily:

We've got to see his dog though, on his couch a couple of

Ed:

We did. That was, that was pretty awesome. Um, the, uh, the, the biggest, the biggest thing, and we, we do have stories. We didn't get to tell them because Rory is the best storyteller of the bunch. Um, and so we, we didn't get a lot of stories, but I will say this, the valuation piece as it goes, as you go through that process is setting the table for the entire P. E. hold period, because the only way they make money is If they make money on the investment and most of the money in the investment most They'll tell you it's in the execution, but it's like anything else you make most of your money on the buy and so they'll The, that by valuation is absolutely critical for the private equity piece. And if they overvalued, regardless of how nice a guy you are, how nice a gal you are, they are going to get very irritated if they figure out they overpaid and they're not going to hit the return hurdles, even if you're doing fine. Um, but fine isn't fine enough for them. And the, on the flip side, if they underpay, they're going to be ecstatic and you're going to be irritated. So there is a, there is a kind of a fine point of, you know, trying to get to the right answer. Um, like I said, most of the deals that I've had to go into are ones that were just grossly, like the last one was just grossly, grossly valued, grossly off. Um, I'm not going to say misrepresented. I don't want to get in trouble. I would just say the valuation was significantly higher than I would have paid for it, but so are most private equity transactions. And you end up spending a lot of your time trying to scramble to get the return that the, that the, was underwritten originally. Um, and I'm dealing with another one of those right now. Um, where we, I did the valuation, the valuation as underwritten, and then I showed what the valuation is today, and it was a, uh, a very eye opening. Um, presentation for the private equity folks as to what just a couple changes and assumptions um, over the last two years have done to their investment thesis. So those are the kind of things that, you know, that initial valuation is going to set the table for the entire hold period and set a lot of the attitudes and emotions during that hold period. So, just be prepared and that's probably the most critical piece of the hold period. Entire deal process is getting that valuation, right?

Emily:

Set the table right. That can be our takeaway message. I was trying to think of something clever for like a, for like a reality show. The only thing that's coming to mind is like the bachelor because that's what I watched in college. Um, but, uh, less tears, more roses. We'll leave it with that. There we

Ed:

Beautiful.

Emily:

We'll catch you next time on the private equity experience podcast.