- July 29, 2022
- Posted by: Ramkumar
- Category: Posts
Exit Multiples In VC Pricing
Investors 𝐩𝐫𝐢𝐜𝐞 𝐨𝐫 𝐯𝐚𝐥𝐮𝐞 𝐜𝐨𝐦𝐩𝐚𝐧𝐢𝐞𝐬 when investing/raising capital in a business, and #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 #TAM with a #competitiveadvantage.
Let me substantiate.
A private equity firm acquires a personal business at 𝟭𝟱𝘅 𝗘𝗕𝗜𝗧𝗗𝗔 𝘄𝗶𝘁𝗵 𝗮𝗻 𝗘𝗕𝗜𝗧𝗗𝗔 𝗼𝗳 𝟭𝟬%. The PE firm improves the 𝐭𝐚𝐫𝐠𝐞𝐭’𝐬 𝐄𝐁𝐈𝐓𝐃𝐀 𝐭𝐨 𝟐𝟓% at the end of its holding period. Suppose the PE firm sells it to a buyer at the same 𝟭𝟱𝘅 𝗘𝗕𝗜𝗧𝗗𝗔, 𝗶𝘁 𝗿𝗲𝗮𝗹𝗶𝘇𝗲𝘀 𝗮𝗻 𝗜𝗥𝗥 𝗼𝗳 𝟯𝟮% 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. 𝐂𝐨𝐦𝐩𝐚𝐧𝐢𝐞𝐬 𝐟𝐨𝐫 𝐈𝐏𝐎 𝐝𝐞𝐦𝐚𝐧𝐝 𝐚 𝐯𝐚𝐥𝐮𝐚𝐭𝐢𝐨𝐧 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐞 𝐭𝐡𝐞𝐲 𝐠𝐨𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐥𝐚𝐬𝐭 𝐫𝐨𝐮𝐧𝐝. The innocent retail investors subscribe to these IPOs thinking that these firms will continue to outperform.
As 𝗰𝗼𝗺𝗽𝗮𝗻𝗶𝗲𝘀 𝗺𝗼𝘃𝗲 𝗳𝗿𝗼𝗺 𝗼𝗻𝗲 𝘀𝗲𝗹𝗹𝗲𝗿 𝘁𝗼 𝗮𝗻𝗼𝘁𝗵𝗲𝗿, 𝘁𝗵𝗲 𝗲𝘅𝗶𝘁 𝗺𝘂𝗹𝘁𝗶𝗽𝗹𝗲𝘀 𝘀𝗵𝗼𝘂𝗹𝗱 𝗿𝗲𝗱𝘂𝗰𝗲, 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.