What is my Business WORTH?
How to Value a Business is a Complicated Question
This is a common question asked by our clients and prospects. Now that so many Baby Boomer business owners are more seriously contemplating their succession plan options, how to value a business is coming more to the fore. The first thing to understand is that a business can have a wide range of values depending upon the how a business owner decides to exit their business. Though there are many options, for now we are going to focus on valuing businesses from the perspective of a buyer.
What is EBITDA?
Even though we are going to approach business valuation assuming that you want to sell your business, only a professional valuation expert can give you a truly accurate valuation on your business. But for simplicity we have narrowed the range of exit options to a sale. So what do potential acquirers care about? At the most fundamental, potential buyers care about–current and future cash flows.
To get a handle on cash flow, a potential buyer will try to estimate free cash flow using a metric called Earnings Before Interest, Taxes, Depreciation, and Amortization, which is also known as EBITDA (commonly pronounced “ee-bit-dah”). This is a straightforward computation that adds back Interest Expense (and subtracts Interest Income), Tax Expense, Depreciation and Amortization to your net income. Why adjust for these items you may wonder. Depreciation and Amortization are non-cash expenses and are always added back to cash flow. Interest and Taxes can be rather variable depending on the current business use of debt, and other tax-related factors and are eliminated from net income to produce a “normalized” free cash flow.
How are Multiples of EBITDA Used?
With an estimated EBITDA in hand, a potential acquire can compare the cash flow potential of different businesses to identify acquisition targets. Generally, businesses are valued in multiples of EBITDA that are adjusted for a number of factors. As a multiple increases, so does business value. So a business with $1M of EBITDA and a multiple of 4x, could be valued at $4M. Multiples represent the potential return an acquirer needs to move forward with an acquisition. You can compute the acquirer’s return by taking the reciprocal of the multiple. In our example above, a multiple of 4x equates to a 25% return (1/4x = 25%). A multiple of 3x equates to a 33% return, and so on and so forth. Multiples for privately held businesses typically range from 2x to 11x.
What Kind of Multiple to Expect
You are probably wondering what factors control the multiple for privately businesses given that the expected return ranges from 50% (2x) to 9% (11x). The first and foremost is the lack of an open market to buy and sell privately held businesses. If there was a liquid market for privately held businesses, then multiples would be higher. The relative illiquidity of the market for privately held business increases return levels just like coupon rates increase and decrease based on the quality of different bonds. The next level of factors pertain to business size and industry. The greater the business size, the greater the multiple. And as you can imagine, businesses in certain industries are in greater demand than others.
How to Influence Your EBITDA
The next set of factors are the ones that a business owner, can influence. Though they require varying amounts of time, there are many items a business owner can affect to increase their business multiple. The first and foremost is revenue growth. Are you able to grow revenue? A decreasing revenue trend will be a significant red flag for potential acquirers. Next, have you established protection around your intellectual property? Do you have trademarks? Are they registered? How about your logo, is it registered? Have you had your CPA firm review your financial statements recently? Do you have reviewed financial statements? How do your financial metrics for profitability and working capital use compare to your industry cohort? Are your IT systems current with the latest technology for security and speed? Does your company have outstanding litigation with other companies and/or employees that needs to be resolved?
Think about the types of things that a prudent acquirer would try to uncover during due diligence and work to resolve any obvious or latent risk items that can impact how a buyer will value a business well ahead of time. Frequently business owners spend little time getting into these details only to have the acquirer demand price concessions at close, for items that surfaced during due diligence.
Lastly, the most important way you can influence your multiple is to build a team to help you with the process. Many business owners become distracted from their typical day-to-day sales and marketing activities need to maintain/grow the top line, which can have disastrous effects the value of a company. As a CFO services firm, we help business owners build a team, address how to value business and much more.