Rules Of Thumbs

Private equity buyout valuations have historically averaged about 4 to 5 times EBITDA. In recent years (2005 and beyond), private equity buyout valuations have been closer to 10x EBITDA. Insiders agree that this will limit Private Equity (PE) returns to mid- to low teens in sharp contrast to their historical 30% IRRs.

For a company that is growing at a steady-state rate, 10x EBITDA (earnings before interest, taxes, depreciation, and amortization, see rule of thumb: Cash Flow). This is essentially providing you with a proxy for a financial valuation theory known as the Dividend Growth Model. This theory states the value of a company is given by dividing its annual cash flow by the appropriate discount rate less the company s growth rate. Therefore, the 10x EBITDA rule of thumb comes from dividing the current years estimated cash flow by a 10% (net of growth) discount rate.

Venture capitalists typically seek a 5x-10x return on their investment. I have used a Rule of Thumb I have coined the “Factors of 10’s”. It goes like this: If a VC wants a 10x return on a $6 million investment (for, say, 60% of the company)

• The VC would need to cash out at $60 million
• Which implies that the company would have to be worth $100 million when sold
• And the entrepreneur’s company aims for 10% of the addressable market
• The company would need revenues of perhaps $50 million (for a valuation of 2x Revenue)
• Which implies a total addressable market size of $500 million, or an addressable market of 10x the company’s revenues.

This is based on a lot of broad assumptions, especially that the company would not need any further funding.