Implementation Issues of Exit Multiples

While the estimation of exit values is rather straightforward, there are four key implementation issues that we have to keep in mind when using this method. Three of them we have already discussed in great detail in the separate module Relative Valuation (Multiples), namely:
 

  • Are there comparable firms? Truly innovative startups often do not have large set of peers for which we have all the relevant information (see also the discussion here).
     
  • What is the "correct" value driver? Put differently, does EBITDA  or another financial metric truly capture a firm's ability to generate value as well as the market's willingness to pay?
     
  • What are comparable valuation situations? As we have discussed in the module Relative Valuation, different types of transactions have fundamentally different implications for liquidity, control, and synergy potential. Therefore, they will generally result in systematically different valuations! We have to make sure that we use multiples that reflect the same kind of transaction that we envisage for the exit (e.g., takeover by a strategic partner vs. sale of a minority stake to a financial sponsor).

  

In the context of exit valuation, there is one big additional challenge: We apply a valuation multiple that we observe today (or in the past) to a hypothetical transaction that will take place in the distant future! Put differently, we factually assume that the company's market environment as well as the investors' demand for such companies will not materially change during the forecast horizon. This is a very strong assumption, which is hardly ever met in reality.
 

One way to address this issue is to use valuation multiples of companies that operate in a similar environment today as we envisage it for the firm in question at the end of its forecast period.
 

  • Those could be the older, more mature firms in the industry.
     
  • We could also use current valuation multiples from different (but related) industries. Those could be the industries that were at a similar stage of development 5-7 years ago as our industry in question is today. For example, to estimate the exit value of an investment in a social media company, one could use current market multiples from the e-commerce industry.

   

Example

Let us illustrate this latter issue with a simple example. Suppose a hypothetical company Flap is working on an innovative business idea for social networks. It is early 2017. Inspired by the recent Initial Public Offering (IPO) of Snap, the founders of Flap start wondering (dreaming) about the potential value of their own venture. Here is the information we have:
 

  • According to the firm's business plan, exit could be possible in 7 years. By then, the firm's revenues are expected to be 200 million.
     
  • Shortly after the IPO, the market capitalization of Snap was approximately 35 billion. According to the 2016 financial statements, Snap's revenues were 400 million.
     
  • Venture capitalists require an annual rate of return of 40%.

  

Because their business idea is similar to Snap's, they conclude that Snap is a valid comparable firm and therefore conduct the following valuation of Flap (in millions):
 

  • Market multiple: EV/Sales of Snap = 35'000/400 = 87.5
     
  • Value driver of own firm at time of exit (in 7 years): 200 millions
     
  • Exit value7 = Market multiple of Snap × Expected Sales7 = 87.5  × 200 = 17'500 million
     
  • Present value of Exit value7 = \( \frac{\text{Exit value}_7}{1.4^7} \) = 1'660.

  

Put differently, these computations imply that the current value of Flap is roughly 1.7 billion.

  

Unfortunately, this valuation is highly unrealistic. Why? Simply because the market will mature between now and Flap's expected exit point in 7 years. At the time of its IPO in early 2017, Snap was able to fetch such a high valuation multiple because the firm was expecting to grow its revenues tremendously over the next few years and because the market was rather excited about these growth prospects. But all of this is irrelevant for our company Flap. In all likelihood, the social network industry will mature considerably until Flap's potential exit. This means that the typical business case in the industry will convert from "no revenues and tremendous growth potential" to "stable earnings and moderate growth." The result of the declining growth expectations is that valuation multiples will come down dramatically. With other words, it would be unreasonable to assume that Snap will be able to maintain a EV/Sales multiple of 87.5 over the next 7 years!

   

But what coud be a reasonable multiple? We could look at social network companies that have been on the market for longer than Snap. Facebook, for example, went public 5 years earlier and was valued at an EV/Sales multiple of approximately 14 at the time of Snap's IPO (down from almost 30 when Facebook went public).
 

However, using Facebook's valuation might still be overy optimistic for Flap, since the company is a pioneer and global market leader. A more realistic approach could be to take the typical EV/Sales multiple of software internet companies. In early 2017, this multiple was approximately 6.5.

  

Clearly, the impact on the resulting valuation is quite dramatical. At a revised exit multiple of 6.5, the expected exit value drops to 1.3 billion and its present value to 123 million:
 

  • Revisesd Exit value7 = Market multiple of software internet companies × Expected Sales7 = 6.5  × 200 = 1'300 million
     
  • Present value of Exit value7 = \( \frac{\text{Exit value}_7}{1.4^7} \) = 123 million.

  

Arguably, this valuation could still be at the higher end because, even if Flap makes it past the next 7 years, the likelihood that it will ipo could be rather small.  

  

This example has illustrated that, while the use of exit multiples is rather straightforward, the result is highly sensitive to the many implicit assumptions we make. Since relative valuation treats the firm as a black box, it is not always easy to see what these assumptions are and how exactly they affect the resulting valuation. This is a general challenge of relative valuation, but it is especially critical in the context of startup financing because of the rapid changes in the business models and the market conditions.

  

To close this chapter, let us briefly revisit some of the implicit assumptions we make when working with such multiples.