Exit Multiples In VC Pricing

Exit Multiples In VC Pricing

Investors ๐ฉ๐ซ๐ข๐œ๐ž ๐จ๐ซ ๐ฏ๐š๐ฅ๐ฎ๐ž ๐œ๐จ๐ฆ๐ฉ๐š๐ง๐ข๐ž๐ฌย when investing/raising capital in a business, andย #privateequity firms/VCs generally price companies using multiples. The rationale is that the investors would exit their investments after a holding period and look at the target IRR to assess their investment’s profitability.

For instance, when acquiring a private company, a PE firm might assume that if they receive a business for 15x EBITDA, they should sell the business at the exact multiple after their holding period. Unfortunately, this reasoning has a flaw unless the firm has a high #TAMย with aย #competitiveadvantage.

Let me substantiate.


A private equity firm acquires a personal business at ๐Ÿญ๐Ÿฑ๐˜… ๐—˜๐—•๐—œ๐—ง๐——๐—” ๐˜„๐—ถ๐˜๐—ต ๐—ฎ๐—ป ๐—˜๐—•๐—œ๐—ง๐——๐—” ๐—ผ๐—ณ ๐Ÿญ๐Ÿฌ%. The PE firm improves the ๐ญ๐š๐ซ๐ ๐ž๐ญ’๐ฌ ๐„๐๐ˆ๐“๐ƒ๐€ ๐ญ๐จ ๐Ÿ๐Ÿ“% at the end of its holding period. Suppose the PE firm sells it to a buyer at the same ๐Ÿญ๐Ÿฑ๐˜… ๐—˜๐—•๐—œ๐—ง๐——๐—”, ๐—ถ๐˜ ๐—ฟ๐—ฒ๐—ฎ๐—น๐—ถ๐˜‡๐—ฒ๐˜€ ๐—ฎ๐—ป ๐—œ๐—ฅ๐—ฅ ๐—ผ๐—ณ ๐Ÿฏ๐Ÿฎ% for its investment. However, if the industry’s EBITDA average is 25-30%, it becomes tough for the new buyer to improve the target’s EBITDA further. Thus the buyer should never buy the target at more than 10x EBITDA.

We face these issues in the IPO markets. ๐‚๐จ๐ฆ๐ฉ๐š๐ง๐ข๐ž๐ฌ ๐Ÿ๐จ๐ซ ๐ˆ๐๐Ž ๐๐ž๐ฆ๐š๐ง๐ ๐š ๐ฏ๐š๐ฅ๐ฎ๐š๐ญ๐ข๐จ๐ง ๐ฆ๐ฎ๐ฅ๐ญ๐ข๐ฉ๐ฅ๐ž ๐ญ๐ก๐ž๐ฒ ๐ ๐จ๐ญ ๐ข๐ง ๐ญ๐ก๐ž ๐ฅ๐š๐ฌ๐ญ ๐ซ๐จ๐ฎ๐ง๐. The innocent retail investors subscribe to these IPOs thinking that these firms will continue to outperform.

As ๐—ฐ๐—ผ๐—บ๐—ฝ๐—ฎ๐—ป๐—ถ๐—ฒ๐˜€ ๐—บ๐—ผ๐˜ƒ๐—ฒ ๐—ณ๐—ฟ๐—ผ๐—บ ๐—ผ๐—ป๐—ฒ ๐˜€๐—ฒ๐—น๐—น๐—ฒ๐—ฟ ๐˜๐—ผ ๐—ฎ๐—ป๐—ผ๐˜๐—ต๐—ฒ๐—ฟ, ๐˜๐—ต๐—ฒ ๐—ฒ๐˜…๐—ถ๐˜ ๐—บ๐˜‚๐—น๐˜๐—ถ๐—ฝ๐—น๐—ฒ๐˜€ ๐˜€๐—ต๐—ผ๐˜‚๐—น๐—ฑ ๐—ฟ๐—ฒ๐—ฑ๐˜‚๐—ฐ๐—ฒ, the exception is unless the new buyer brings a skill set that can enhance the target’s value and even the buyer should negotiate for a lower multiple and retain excess returns to itself.

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