Many businesses rely on simple techniques to estimate the value of their company. Business valuation firms use slightly more sophisticated methods such as discounted cash flow model, public market comparisons and other asset value methods.
The numbers these methods produce are certainly useful for business owners and are accurate enough to be used for tax planning, estate planning and divorce settlements. However, many business owners are surprised to learn that these calculations do not necessarily reflect the actual market value of the business when it goes up for sale.
Determining the true market value of a business is one part art and one part science. You may be able to run an excel formula to determine your scientific value, but to understand the ‘art’ portion you need to be able to see how your company is likely to be perceived and valued by a potential buyer.
Looking at your business through the lens of a buyer can be a very difficult task for business owners, but it is a crucial step in the sales process. By fully understanding how your company looks to potential buyers, it gives you the opportunity to improve the specific aspects of your business that they most value.
This will enable you to develop an exit strategy that will close the gap between what you feel your company is worth, and how buyers perceive your value.
In the world of mergers & acquisitions of profitable mid-sized companies, there is one method that is used more frequently than any other when valuing a business for a potential acquisition. This method is known as the EBITDA multiple calculation.
What Is EBITDA And Why Is It Important?
Buyers generally form the basis for the price they offer by calculating and analyzing a financial measurement called EBITDA (Earnings Before Interest Taxes Depreciation & Amortization). To calculate EBITDA, start with the pre-tax net income of the business and add back interest expense, depreciation and amortization.
A company’s EBITDA is then adjusted for unusual one-time expenses or items that will not continue under new ownership, such as non-business related travel, auto expenses, excess owner salaries, excess rent, etc.
After the company’s EBITDA is calculated, it is multiplied by a number (the “multiple”) to arrive at a value. The multiple applied to a particular business will vary based on several factors, but for profitable mid-sized companies, multiples generally range from 5 to 8 times EBITDA. High margin, niche businesses with a strong track record of revenue growth and profitability will command high multiples, while low-value-added, commodity businesses will tend to garner lower multiples.
As a general rule, larger companies receive higher multiples than smaller companies, and companies that operate in capital intensive industries tend to sell for lower multiples due to the continued capital investment necessary to maintain the business.
So What Does That Mean For My Business’s Sale?
All businesses are sellable, however the real question we need to answer is, “Is my business valuable to someone else?” In the end, the question is what is it worth to you on a go-forward basis and what is it worth to an acquirer, as those are always different numbers.
A good M&A advisor will help you bridge that gap (often over some period of time) and help you optimize value to reduce the gap between your expectations and a potential acquirer’s viewpoint.
Can I Increase My Business’s Value Before Sale?
Absolutely! The first question to ask yourself is, ‘What do we have to work with?’ The value drivers of every business are the same yet the execution of your plan is unique to the business.
Here is what we do know. Acquirers must have two comfort factors (or expressed differently, really only care about two things):
- Reliability of cash flow from the business – key concept being reliability in the short-term which answers their question of “Will this have value after I take over?”
- How likely is that stream of cash flow to continue over the next 3-5 years? This answers the question “How risky is my investment?” along with “What guarantees (or likelihood) I will have to get my desired return?”
Fundamentally, all buyers want “sure things” with “no risk” – the higher you are on the food chain on these two items the more valuable you are.
Questions To Ask Yourself To Determine True Value
To really have a full understanding of your business’s value ask yourself the following questions:
- Has my EBITDA been steady and predictable for the last 3 years?
- Do I have long-term customers on board and some under contract?
- Do I have a management team in place that can operate the business without me?
If you can answer yes to these three questions, you are probably ready to move forward on the process and experienced middle-market M&A advisors like our team at JD Merit will be eager to speak with you.