Once you start meeting with investors’, you will find that they and their financial advisers start talking in jargon about your business in terms that may as well be in Klingon.
EBITDA, IRR, NPV, leverage, terminal value, net cashflow, free cashflow, blah…blah…blah…
Here’s a short explanation of investors’ jargon or the key terms used, so that you understand what they are saying and also understand how your business plan projections are appraised.
1. EBITDA – Earnings before interest, tax, depreciation and amortisation
These are the annual earnings projected in your business plan, which is the net profit with debt interest, asset depreciation and taxes added back. This is the amount of cash that the business generates that is available for re-investment into assets and paying off debts, debt interest and taxes. So the higher the EBITDA, the better although in the start-up phase, EBITDA could be negative for a year or two until the business generates sufficient revenues.
2. Net cashflows
This is the difference between the cash inflows and outflows for a period. It starts with EBITDA and then takes into account changes in working capital annually, i.e. the changes in debtors, creditors and stock. From this, corporation taxes are deducted to get net cashflows. In the start-up phase, net cashflows would be expected to be negative until the business generates sufficient revenues.
3. Free cashflows
This is the cash remaining after capital expenditures are deducted from net cashflows. It has taken into account all the cash required for the business to expand. It is the cash left for distributing to shareholders, debt holders and other stock holders. This is the most important figure for investors’ since some financial analysts use this to value businesses.
This is the amount of debt that can be raised given the EBITDA and free cashflows available. Investors’ will want to leverage a higher debt as possible since it preserves their cash and generates better returns for them, subject to the interest rates being offered of course. Usually, banks look at how many times the EBITDA would cover the annual interest payments and also how much free cash is available to repay the principal off the loan.
5. Terminal Value
This is the value of the business estimated at the projected time the investor wants to exit. It can be through floating the company on a stock market or by selling it to a another company. There are many valuation methods but one of the more common is to take the projected EBITDA in the year of exit and multiply it by a factor. Usually this relates to a figure being used in that industry sector and can vary from 3-4 to sometimes 10. However, if the business is expected to boom such as some tech companies, then valuations can get crazy, like in the Dot com boom.
5. NPV – Net Present Value
Net present value is the sum of all the free cashflows of the business for the projected number of years, discounted by a factor which relates to the cost of capital. This cost of capital or discount rate usually ranges from 3.5% to 10%. A factor is then derived using this cost of capital and the figure gets smaller as every year progresses. This is to take into account the reducing value of money over time. So the cashflow in year 1 will get multiplied by a factor of 1 and in year 2, using 10% as the discount rate the multiplier is 0.909 (1 divided by 1+10%) etc. Over the projected investment period say 5, 7 or 10 years the NPV should be positive including the terminal value.
6. IRR – Internal Rate of Return
This is the most important number for financial analysts and investors’ since it gives the rate of growth a project or business generates. It is the rate that makes the NPV of a range of cashflows equal to zero. For example, if an investor invests £10m at the outset and the business loses £2m in year 1, loses £1m in year 2 and then generates free cashflows of +£2m per year over the next 5 years and with a terminal value of £30m in year 7, the IRR calculates at 20%. Investors’ will look at a range of opportunities and the higher they estimate the IRR, the more likely they will invest into that project.
However, it is worth remembering that the above jargon only gets used after an investor is convinced that the business is something they would like to invest into and those initial reasons can be very subjective indeed.