In an office-based work environment, smart shoes are essential. However, with the shift from boardroom meetings to video calls, the need for formal attire has become limited to clothing seen from the waist up. This, in turn, has caused the demand for comfortable shoes to climb through the roof, while the need for formal footwear, like stiletto heels, has dropped sharply — pun intended.
The German footwear brand Birkenstock was ready for this transition with its famously comfortable sandals. Birkenstocks are adored for their arch support and hipster appeal — hardly the purview of high-finance — but at least two private equity firms expressed interest in buying the sandal manufacturer, which was valued at between € 4–4.5 billion*. L Catterton, the company behind fashion giant Louis Vuitton, finally won the bid, purchasing Birkenstock in February 2021**.
The Purpose of a Business Valuation
While most can only dream of selling their business for that amount of money, knowing how to value a business, no matter its size, is essential. A valuation may be required for periodic reporting (i.e., feedback to investors), investment analysis, capital budgeting, raising capital, selling shares in the company, or selling the entire business, as is the case with Birkenstock.
Birkenstock is a well-established company (over 200 years old), and the valuation techniques used for this golden oldie are very different from those used if the company were still in its infancy. Aligned with our vision at Creative CFO to create a world where more SMEs succeed, we will focus on explaining the valuation techniques that would be helpful for the “next Birkenstock.”
How do we Value a Business?
Various valuation methods are acceptable regarding the International Private Equity and Venture Capital Valuation (IPEV), and using two or more is considered best practice for valuing a company. This allows the business to be seen from different perspectives, resulting in a more comprehensive and reliable view.
The methods we often use to value companies in the start-up and growth phase include two Discounted Cash Flow (DCF) methods, the Venture Capital (VC) method, and two qualitative methods: the Scorecard and the Checklist Method. The DCF methods we will describe in this article represent the most well-known approach to company valuation. Academics recommend these methods and are also used as a daily tool for investment analysts.
The DCF Methods: The Go-To Guys
The two DCF methods are “DCF with LTG” (Long Term Growth) and “DCF with multiple”. Using these methods, we attempt to derive the company’s value today based on projections of how much cash a business will generate. From a technical perspective, we derive the present value of the projected cash flows that the company is forecasted to generate each year in the future by discounting these cash flows by a market risk rate. In essence, this takes into account the time value of money and reduces the cash flow each year, acknowledging that R100 in a few years isn’t worth as much as R100 today.
In South Africa, more than 70% of SMEs fail within their first five years. This means it is extremely important to weigh projected cash flows by the probability of an SME’s survival. In determining an appropriate risk rate, we consider risks related to the company’s specific industry, size, stage of development, and perceived profitability. Take a look at our SME’s Guide to Understanding Your Data for deeper insight!
Long Term Growth or a Multiple?
Once we have modelled the cash flow over a specific period by constructing a financial forecast, we need to assign a Terminal Value (TV) to the business. The TV represents potential future cash flow, beyond the projections we determined through the financial forecast.
We use one of two DCF methods to calculate the TV: DCF with LTG or DCF with multiple. DCF with LTG assumes cash flows will grow constantly beyond our forecast. In contrast, DCF with multiple assumes the TV is the company’s exit value (the price the investor receives upon sale), which is computed by incorporating an industry-based multiple of EBITDA. The multiple is derived by considering the EBITDA average of recently acquired companies compared to their value (e.g. if Company X was sold for R10 million but has a TV of R800,000, the applied multiple would be 12.5).
Once we have calculated a specific business’s projected cash flows and TV, we apply an illiquidity discount to complete the valuation. Illiquidity (the opposite of liquidity) refers to how difficult it is to convert an asset into cash. The illiquidity discount is, therefore, built into acknowledging that selling an SME (liquidating) is not as easy as selling a large, well-established company like Birkenstock.
The illiquidity discount essentially means that a big, Birkenstock-type company will be more expensive than a small, anonymous one. Therefore, the buyer of the small company will receive a more substantial discount because it would be harder to exit (sell).
Using More Than One Method
Aligned with best practice, we use the other three methods mentioned above to derive a weighted average of the valuations. This leads us to our final valuation – how much we think the company is worth. The weights of each method are applied according to the stage of the business (i.e. idea stage, development stage, start-up stage, and growth stage). The DCF methods make up most of the weight once the company is in the start-up stage and beyond.
The First Step to Scaling Smart
A Business Valuation requires consideration of a plethora of different factors and can be tricky to get right, especially for a company in the early stages of operations. Knowing the value of a concept or a business model is vital to scaling into a world-class company.
At Creative CFO, we love to see the SMEs of the world become the Birkenstocks. Contact us, and let us help you take the first step.
We empower you to grow the right way – sustainably, profitably and in the right direction.
References
*Birkenstock sold to LVMH-backed group in €4bn deal. The Financial Times. 26 Feb 2021. https://www.ft.com/content/5d511022-46db-403e-9784-eb3807f918f9
**Bain, Marc. The company behind Louis Vuitton is now backing Birkenstock. Quartz. 26 Feb 2021.
