If you are a business owner, you likely have a dozen questions regarding the value of your company. Besides wanting to know what the total value is today, you probably have other related questions, such as:
- Will some buyers pay more than other buyers?
- What can I do to increase the value?
- When is the best time to sell?
- How long will I stay on after closing?
No doubt, there is a lot consider when selling a business. Let’s focus first on “value”.
Focus On Earnings
Good buyers focus on the potential earnings from your business and the future risks to achieve that stream of income.
So what exactly are earnings? The most common measure is EBITDA – Earnings Before Interest, Taxes, Depreciation, and Amortization.
Because a buyer may have a different tax rate and a different capital structure, they exclude your unique tax rate and interest payments. Similarly, depreciation and amortization are non-cash expenses, and companies may have varying accounting policies regarding how items are depreciated or amortized, so buyers typically look at earnings before these non-cash expenses.
EBITDA is an attempt to measure cash flow from the business on an apples-to-apples basis.
In order to calculate EBITDA start with your net income before corporate taxes, add back your interest expense, depreciation, and amortization, if any, to arrive at EBITDA.
Oh and then there is “Adjusted EBITDA”. Starting with your financial statement EBITDA, you must adjust for expenses that won’t occur under a new owner, such as over-paying your family members working in your business, that one-time legal expense for that sticky issue you had last year, or the Lamborghini that you use for “business development”. There are many others, and it takes a thorough review of your financials to prune out these unusual or non-operating expenses or income items.
Apply The Appropriate Valuation Multiple
The next part appears relatively simple, but in reality has complex math behind it. Look at the table below, and multiply your Adjusted EBITDA by the respective EBITDA multiple given your industry and EBITDA size. For example, if you own a healthcare company with $1 million in EBITDA, multiply it by 5.5x and the valuation is $5.5 million.
A complete or formal valuation will include other analysis and computations, but this provides a quick (and dirty as we say) value range for your company.
|EBITDA Multiples by Industry & EBITDA Size
|$0 – $1M
|$2 – $5M
|$6 – $10M
|Media & Entertainment
The Impact of Growth Rates and Business Size on Valuation
Comparing changes over many years also reveals some trends. Higher growth industries such as information technology and media have higher multiples while low growth industries such as construction have lower multiples. In general, higher growth gets a higher valuation.
Since buyers are paying for future cash flow and growth results in higher profits, it makes sense they would pay more.But what is this magical table? It is a summary of implied valuation multiples based on a large survey of actual sale transactions (“sales comps”), in this particular case compiled by Pepperdine University. The business school conducts a survey each year of business brokers, investment banks, CPAs, and others involved in the sale of companies.
Notice how the values increase from the first column to the third column. In general, the larger the company, the higher the valuation. Larger companies tend to have more “quality” earnings, such as: complete management teams, better accounting systems, and more thorough business processes. In other words, there is less risk that some unforeseen negative event will occur in the future. Similarly, a smaller company may be dependent on one or two key employees or customers, and if something happens to one of them, earnings will likely suffer.
How Risk Impacts Business Valuation
In addition to projecting your earnings, a buyer assesses the risks to the earnings. If you have strong recurring revenue from lots of small customers, the earnings will likely keep coming in for years.
For example, an information technology company selling software constantly needs to find new customers just to maintain its revenue level. Compare that to another a similarly sized IT company that has a monthly maintenance fee – which has more value? The company with recurring monthly fees has a greater value because the risk of revenue falling is much lower.
The higher valuation and lower risk from recurring revenue has been a large contributing factor to the IT industry moving to its subscription-based sales model from an “off-the-shelf” sales model.
Businesses with a defensible niche are valued higher than businesses with low barriers to entry. Examples of high barriers to entry include sophisticated technology, heavy investment in specialized equipment, or a list of loyal customers developed over decades in the business.
Likewise, significant risks to the business decrease the valuation. If you have one or two large customers, the loss of one customer will cause a significant decline in cash flow, so a buyer will pay less for your company. Below are a few risks that typically reduce the value of the company:
- Customer concentration (i.e. customer > 10% of sales)
- Key personnel, such as a key sales person or owner who is a one-person show
- Poor accounting and record keeping
- Risk of technical obsolescence
- High on-going investment in equipment such as a trucking company
Business owners need to continually work to reduce the risks in their business. If the owner suddenly cannot come to work for three months, he/she should have a next-in-command that has the training to take over in their absence. Below are a few actions to reduce risk in your company:
- Management depth with a designated back-up for each key position
- Document your processes and controls
- Back-up your computer systems and have a cybersecurity plan
- Have reviewed financial statements from a well-known accounting firm
- Thorough human resource processes to minimize and handle issues such as sexual harassment
Seek Assistance From Business Valuation Experts
Valuing your business is a very complex process involving a host of factors, so it is difficult to touch on all of the factors in a brief article. Transact Capital Partners would be glad to sit down with you to discuss the value of your business and the best time to exit if that is on the horizon.
Our team is headquartered in Richmond, VA, and we have representatives in Lexington, KY, Orlando, Roanoke, VA, and Chicago, IL. We maintain strict confidentiality and absolutely no future obligation to engage our services.