When it comes to business valuations, beauty is not in the eye of the beholder.
Value is tangible, comparable and often derived from the cost of capital, risk or the opportunity cost of the next best investment. As in marketing, it’s driven by the ROI.
Or, as Warren Buffett is so famous for saying:
Price is what you pay, value is what you get.
Too often business owners base their expected company valuation on things like:
We have worked in the buying and selling of digital services businesses and digital assets, including domain name valuations and acquisitions. Consequently, we know a bit about both the process of buying, how to value agencies and what it means to grow the value of your agency. Here we discuss all three. So, if you’re looking to start a new agency, sell your agency or acquire a existing agency, there should be some helpful pointers in here from which you can glean.
Standard service business valuations apply to most marketing companies, including digital agencies servicing content marketing, SEO, link building, website design and PPC management. In such cases valuations can range from 3x to 5x of EBITDA (earnings before interest taxes, depreciation & amortization) or SDE (seller’s discretionary earnings).
That’s a big range.
Most businesses are going to fall on the 3x side of that range for several reasons:
Significant buyer investment risk exists for investors looking to acquire digital agencies. While good buyers have the vision to see opportunities, they also will have a keen and often overcompensating view of the risks associated with making an acquisition. These risks discount the value of any investment in a private business. Here are just a few.
First, market risk can and will impact the value of a business. The recent pandemic is the perfect example of how outside forces can greatly and immediately have a negative impact on the value of a business. This is often called systematic risk.
Second, small or smaller private companies always include a discount to value because they do not hold the same liquidity preference premium held by public companies. Public companies often hold more sustainable and scalable income, but more importantly, they are liquid. Liquidity means shares can be more easily bought and sold in an active market between two willing buyers and sellers.
Third, internal business risk. There is inherent business risk within the operations and individual market of a given company. This is often referred to as idiosyncratic risk.
Liquidity risk, systematic and idiosyncratic risks will all serve to haircut your company’s value, especially when compared to the next best investment opportunity.
The cost of capital in digital agency mergers and acquisitions is more than just the interest rate of the debt used to acquire the business, which can range from 5% to 20%+, depending on the source and type of capital used (mezz financing can be double the cost of senior debt).
When buyers assess the cost of capital, they also typically take into account comparable “next best investments.
If I’m doing a comparison as a buyer, I might look at it like this. I have $1M to invest in something. In this case, I would compare it against three separate options:
While these are not apples-to-apples comparisons in their risk profile and liquidity, performing this exercise is helpful in determining whether buying a particular business or business asset will be a good investment.
The following chart provided by KKR do a great job comparing the risk/return profile among various asset classes.
In our case, we might ask:
If I were to invest my $1M in a digital agency vs. public stocks or real estate, would my increased return on investment greatly overcompensate me for the increase in comparable risk.
Acquiring a digital agency has significantly more concentrated (non-diversified) risk than simply buying a mutual fund or buying rental properties. As such, the return on investment should greatly overcompensate for the comparable risk.
Most sellers don’t consider this in their own value calculations when it comes to selling their businesses.
Let’s use an example to compare.
Let’s say your digital agency is producing $1M a year in EBITDA.
The seller wants $5M for the business.
You might say,
Well, that’s a great investment! I’m getting 20% return year-over-year on my money! That’ll beat my current stock portfolio.
However, the risk profile and capital cost is significantly higher in this private illiquid investment than in public stocks or even private real estate, especially if the acquisition is financed with debt (which is very often the case).
In addition to the opportunity cost, the cost of capital itself (e.g. APR of acquirer senior and subordinated debt) will also play a role in how to determine the value and willingness to pay in an acquisition. We’ll get to that a bit more in-depth shortly.
But, my business has so much potential! If you do X, Y or Z, it will double. I know it! When it does the buyer will be the recipient of all those gains!
Buyers rarely pay a seller for such potential unless you’re selling a product business ( not a service) business to Facebook. And, that’s not going to happen here.
If you consider the risk profile, cost of the capital itself and the opportunity cost of the next best investment, higher valuations rarely compute for a savvy buyer.
Let’s continue with our previous example of a $1M EBITDA company looking to sell for $5M.
I like to compare such instances using the SBA 7(a) loan program to see if the deal is even fundable.
In SBA 7(a) financing, debt service coverage (DSC) is the way SBA loans are stress-tested based on historical income.
Debt service coverage is computed as follows:
The SBA requires a minimum debt service coverage (DSC) ratio of 1.5x on a monthly basis. They prefer 2x debt service coverage.
While today’s interest rates make the cost of capital in the numerator above less than historical averages, most assumed valuations do not meet the 1.5x threshold.
At a $5M, 6% annual interest (which is very low) and a 10 year AM schedule (typical for SBA), the monthly principal and interest is roughly $55K.
If we throw that into our annual DSC calculation, we’re looking at DSC=$1,000,000/($55,000×12)=1.51
In other words, we can barely even finance the deal at a $5M valuation, assuming historical income and the fluctuating interest rate will continue forward at their current levels.
In order to boost the value of your digital agency, you’ll need to make it both scalable and sustainable. Scalability and sustainability require one or more of the following:
In other words, you’ll be aiming toward creating a real business, not a one-man shop. Real businesses include quality team members and systems and processes that create reliability of services and outcomes for clients. The implementation of such standard operating procedures ensures the business itself will exist long after any single owner has had his/her hands on it.
Because we have worked as both buyers and sellers of businesses and because we provide a white label SEO service to other agencies, we know a thing or two about what it takes to build, run, buy and sell a digital agency. We would love to connect with you and your team regarding your next transaction and how we can help. Get in touch!