Growth Capital is the Bridge to Valuation Gains

Posted on: February 4th, 2021

growth capital

Business size is everything when it comes to valuation. Larger companies receive higher valuations than smaller companies. Particularly in the middle market, valuation multiples increase at even modest EBITDA level break points. A company with only $3 million in EBITDA may be valued at 5 times EBITDA whereas a Company with $5 million in EBITDA may be valued at 7 times EBITDA. That is a 40% valuation premium based on quantity of EBITDA. This valuation arbitrage has always existed, but it is more apparent now as there are more private equity funds focused on the mid to upper tier sized companies in the middle market.

Whereas 25 years ago, there were many funds focused on $2 to $5 million EBITDA-sized companies, funds today are concentrated at the $8 million+ EBITDA-sized companies. Companies of this size are more likely to be considered platform companies that funds will pay more for to establish a strategic beachhead in an industry. They will then seek smaller add-on acquisitions at much lower multiples to overlay on the platform company. This bulks up EBITDA and averages down the price of the initial platform acquisition, setting the stage for an exit at a price north of the platform multiple.

Growth Capital for Unlocking Corporate Growth

The question for a business focused on valuation is a simple one. The smaller you are, the less you are worth. The larger you are, the more strategic you are and the more you are worth. Growth Capital is the key to unlocking corporate growth and hence valuation gains. Most companies need to look outside of themselves to find new ways to grow, whether it is a new market, product, or acquisition. Growth Capital is the bridge to get there. Growth capital is either non or minimally dilutive financing that will scale your resources to enable rapid growth.

It supplements the existing financing available to the company to allow for major strategic investments, usually beyond what the company can fund on its own. Its cost can range from 4% to 10% if it is structured as a loan and 12% to 15% if structured as equity investment. If the growth investment has a strong enough return – generally a floor of 25%, per annum, it is a smart move. The growth investment will increase revenue and EBITDA, allowing you to reach into the higher levels of valuation upon an exit.

As the Fed decides to ease interest rates, middle market acquisition financing structures will benefit in a number of ways. The underlying values of middle market companies will increase leading to a higher enterprise value and lower loan to value ratios for existing portfolio companies of acquisition financing lenders.

The role of acquisition financing is infrequently elevated above a functional transactional one. When a business needs financing to acquire, they go to the market and source acquisition financing to supplement their equity investment to close the deal. Despite existing in many different forms, acquisition financing is rarely explained in terms of the value it brings to the acquirer.

Acquisition financing underwriting usually focuses on business and financial issues that underpin the stability of cash flow. Providers of acquisition financing usually validate the durability of a company’s competitive advantage and the depth of its resource base. Environmental issues are usually not a major part of the analysis in today’s service and technology-based economy.