Smith Holland M&A Resources
Using the right EBITDA multiple when preparing your business for sale.
For as many items that are on a seller’s mind when purchasing a business, there likely exist as many inputs into the valuation of said business. No matter the combination of levers pulled, they all contribute to product one out, the company’s income. The Earnings before Interest, Tax, Depreciation, and Amortization -- or EBITDA -- remains the final variable towards an enterprise’s valuation. By understanding all the input sources into the firm’s adjusted bottom line, a seller can feel confident in the price and a buyer can rest assured every operating factor has been taken into consideration.
To run the gauntlet on the complete library of valuation variables would be an exercise for theory. Let us then focus on a handful of important contributors, so that we may instead become practitioners of deal-closing.
Regardless of the success of a business, there are some factors that simply cannot be overcome. Macro influences come in no bigger form than the market itself. When recession levels of business were common at the turn of the last decade, many owners had to face the tough reality of waiting out the storm. They faced the risk of worsening markets and valuation, or selling for drastic discounts compared to normal market conditions. As big as an influence as the market is, so too is its unpredictability. This double-edged sword protects macro-market’s standing as the strongest lever on a company’s valuation.
Focused Customer Base
Although cliche, this saying holds for good reason: don’t hold all your eggs in one basket. The last thing a seller wants to discover, after going through initial negotiations, signing NDAs, and making an offer, is to get into due diligence and find a concentration of revenues from one customer or buyer source. No matter how much verbal confirmation can be communicated between the M&A firm, until thorough diligence is completed will the true sources of revenue be revealed. While this might come at a cost to man-hours behind a computer screen, the attention to detail is essential. A concentrated customer base can signal a red flag for a new owner because if any of those clients leave, the future projected incomes are thrown out the window. However, this does not signal the end of a potential deal. If a strong sales and marketing team is in play or part of the acquisition, then the possibility of growing the existing business is enormous. Most companies move into a selling position for that exact reason, sales have stalled, ideas have stalled, and the decision to march forward might be harder than to transition to a new venture. As a buyer, consider the pros and cons of concentrated customer revenue, and as a seller, be prepared to answer those tough questions.
The value of a company typically does not increment on a linear scale. That means, a company that is worth $10 million usually does have a balance sheet that is merely 10x that of a company valued at $1 million. These tiers are generally industry-accepted, and are that magic variable discussed earlier: EBITDA. The tiers form at $1 million, $2 million, $3 million, $5 million, and $10 million. Expect the level of complexity and financial diligence to move hand-in-hand with the EBITDA tier. These tiers don’t just represent the scope of the deal, but also the clientele involved. Every private equity group sets a preferred range of EBITDA they would like to operate with, so understanding where a business falls comes down to an accurate EBITDA.
Lockstep with the EBITDA Range lever, the role industry plays in company valuation cannot be understated. As simple as look at a pizza parlor versus a roofing company, the employee, materials, processes, and ultimately margins are so differentiating that it would be naive to not consider the industry as a major player in the game of valuations. The multiple placed on EBITDA will be tied closely to the industry, and it is common for other factors to play heavy per industry, such as gross profit and revenue.
Pipeline for Growth
The number one question the M&A team receives on initial inquiry from a seller is valuation. The seller states how long they’ve been in business, the industry, some financials, then pops the big question. While it is a slick segue from the M&A team might be to divert the question with a generic ‘there are many factors involved’, it’s the truth. Just like people, not one business is like another, not even franchises, not even when everyone’s favorite restaurant opens a sister location in another town. It’s not the same. By having a company-tailored plan for next year, three years, five years -- even ten -- will help instill confidence in a potential buyer and even serve as a roadmap for company success under the current ownership.
Sure, there are ballpark valuations, and valuations based on back-of-the-envelope math and recollections from prior years’ tax returns, but until a proper due diligence process and full review of at least three years financials, any valuation given on the spot should be taken with a grain of salt. Maybe even a pinch. Many sellers are so specialized in their industry, they don’t have time to become versed in the full levers of the valuation process. Nor should they, that’s the M&A team’s job! One example is add-backs, or seller’s discretionary expenses. These come in the form of personal car insurance on the company books, or having a few extra meals on the company financials. As long as these can be accurately documented as non-dependent on company operations (and success), most of the time they can be added back to EBITDA. Everyone knows EBITDA is a major factor in valuation, so now the dots are starting to connect. Transparency and communication are key to success to any sale, why not for the sale of a company?
Projections and Beyond
Pro forma statements can bring about the full spectrum of emotions. From trends of growth and continued success to projections of red numbers on a spreadsheet, the future plays a pivotal part in the present. Higher valuations, to no surprise, are awarded to businesses experiencing higher growth, specifically consistent growth, and attributable growth. If a company knows where they are finding success, they can invest more marketing or sales resources to that area and provide continued, reliable cash flows. Nothing puts a buyer’s mind at rest, and a seller’s too, when projections can be based confidently on historical performance and it's the duty of your business broker to make sure that value is properly communicated to the buyers.
Now that we’ve reviewed but a small sea in the ocean of valuation factors, the process of accurately assessing a business’s worth should seem less daunting of a task.
Contact us today for a complimentary evaluation.
444 W Lake Street
Chicago, Illinois 60606
32 London Bridge Street
London SE1 9SG, UK
13155 Noel Road
Dallas, Texas 75240
1055 W. Georgia Street
Vancouver, BC V6E 3P3