Multiples, Demystified

Multiples are tricky things to figure out when you’re valuing a business for sale. Lots of opinions are floating around, most stemming from imperfect information. Uncle Bob’s golf buddy sold his widget store for a million bucks based on a multiple of five! Such “buddy wisdom” can lead you astray. Unrealistic expectations can result in a price point that the market simply won’t support. Your business languishes with little to no buyer activity.

First Things First

So, what is a multiple to begin with? Basically, a multiple is a number by which you multiply the economic benefit enjoyed by the owner of a business. With large businesses, this benefit is frequently expressed as EBITDA, an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. While EBITDA makes sense in the M&A realm, where businesses generating $10 million or more in annual sales are exchanging hands, EBITDA isn’t always the best fit with for small businesses. Besides the difference in sheer size, the owners’ group frequently doesn’t play an active, hands-on role in the operation of these larger businesses. Think passive investors.

In contrast, Main Street businesses are frequently helmed by an owner/operator. It’s also relatively common for the owner/operator to run some personal expenses through the business. These could include their personal health and life insurance, the lease expense for a personal vehicle, which they don’t plan to convey with the sale of their business, or the cell phone plan for their family. After all, such practices are one of the benefits of being a small business owner. In essence, SDE (Sellers Discretionary Earnings, also known as Cash Flow) is EBITDA with a few adjustments, including owner’s compensation and personal, discretionary expenses.

There’s more to SDE than this, but that’s it in a nutshell. While multiples can also be applied to the business’ Gross Revenue, SDE shows how much income a new owner will have to live on and pay off pay debt service incurred by taking out a loan to secure the purchase. When done right, SDE is a buyer’s potential Return on Investment for a given business.

Multiples in Action

How is the multiple determined and used, besides Uncle Bob’s questionable tips? Let’s take a simplified example.

You would like to sell your small to medium-sized business, Widgets R Us. What price should you ask?

Ideally, there’s a lot of market data to inform this decision. In the field of comparable widget stores that have sold (based on sector, size, revenue, location, etc.) what is the average sales price? Say it’s $300,000.

Now, what’s the average SDE of those widget businesses that have sold? Say that is $100,000.

The multiple is the result of dividing the average price by the average SDE. In this case, $300,000/$100,000 = 3.

Let’s further say your business’ average SDE over the last three years comes out to $130,000 because your sales team is good at selling widgets. Nice! The price for your business would be $130,000 x 3 = $390,000.

Ze Plot Thickens

That is a pared down example. In real life, the process can be complicated by the quality (or lack thereof) of the financials, market trends, client concentration, how dependent the business is on you, and a host of other factors.

Keeping with the same example above, let’s say that you’re the genius behind your business’ eye-popping widget sales. Over the years, you’ve cultivated relationships with key clients who refuse to deal with anyone else at your widget shop. How does this effect the transferable value of your business? You’ll need to wrestle with such questions.

But Wait, There’s More…

Also keep in mind that multiples, no matter how fact-based, are not the end-all, be-all. A sophisticated buyer will also take into consideration the income they’ll be earning, after debt service, based on their down payment. This is known on as the Internal Rate of Return. An experienced broker can work with you to understand and interpret all this information. You can drastically help this process by having well organized, professionally-prepared financial records. At a minimum, we like to analyze the most recent three years of P&Ls, tax returns and a current balance sheet to get a clear picture of the performance of your business. Buyers want to study these in-depth, often bringing in their CPA or financial advisor, to understand what they’re potentially getting into!

If there isn’t a lot of useful data to go on, there are some tricks of the trade that are based on way more experience than Uncle Bob’s sample size of one or two stories. Brokers have access to information that isn’t available to the general public. They frequently have experience selling businesses similar to yours. The best sales data aggregates the actual sales price of businesses provided by financial institutions and certified business appraisers. They check and double-check the information that goes into making up the SDE number.

Onward!

It’s well worth your while to consult a knowledgeable expert to make sure you’re valuing your business at an optimal price to both sell the business and maximize your achievable profits.

New Business Opportunities in New Mexico

How to add value to your small business to make it attractive to people seeking to buy a business.

What is the Value of Your Business? It All Depends.

The initial response to the question in the title really should be: “Why do you want to know the value of your business?” This response is not intended to be flippant, but is a question that really needs to be answered.

  • Does an owner need to know for estate purposes?
  • Does the bank want to know for lending purposes?
  • Is the owner entertaining bringing in a partner or partners?
  • Is the owner thinking of selling?
  • Is a divorce or partnership dispute occurring?
  • Is a valuation needed for a buy-sell agreement?

There are many other reasons why knowing the value of the business may be important.

Valuing a business can be dependent on why there is a need for it, since there are almost as many different definitions of valuation as there are reasons to obtain one. For example, in a divorce or partnership breakup, each side has a vested interest in the value of the business. If the husband is the owner, he wants as low a value as possible, while his spouse wants the highest value. Likewise, if a business partner is selling half of his business to the other partner, the departing partner would want as high a value as possible.

In the case of a business loan, a lender values the business based on what he could sell the business for in order to recapture the amount of the loan. This may be just the amount of the hard assets, namely fixtures and equipment, receivables, real estate or other similar assets.

In most cases, with the possible exception of the loan value, the applicable value definition would be Fair Market Value, normally defined as: “The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” This definition is used by most courts.

It is interesting that in the most common definition of value, it starts off with, “The price…” Most business owners, when using the term value, really mean price. They basically want to know, “How much can I get for it if I decide to sell?” Of course, if there are legal issues, a valuation is also likely needed. In most cases, however, what the owner is looking for is a price. Unfortunately, until the business sells, there really isn’t a price.

The International Business Brokers Association (IBBA) defines price as; “The total of all consideration passed at any time between the buyer and the seller for an ownership interest in a business enterprise and may include, but is not limited to, all remuneration for tangible and intangible assets such as furniture, equipment, supplies, inventory, working capital, non-competition agreements, employment, and/or consultation agreements, licenses, customer lists, franchise fees, assumed liabilities, stock options or stock redemptions, real estate, leases, royalties, earn-outs, and future considerations.”

In short, value is something that may have to be defended, and something on which not everyone may agree. Price is very simple – it is what something sold for. It may have been negotiated; it may be the seller’s or buyer’s perception of value and the point at which their perceptions coincided (at least enough for a closing to take place) or a court may have decided.

The moral here is for a business owner to be careful what he or she asks for. Do you need a valuation, or do you just want to know what someone thinks your business will sell for?

Business brokers can be a big help in establishing value or price.

Creating Value in Privately Held Companies

“As shocking as it may sound, I believe that most owners of middle market private companies do not really know the value of their company and what it takes to create greater value in their company … Oh sure, the owner tracks sales and earnings on a regular basis, but there is much more to creating company value than just sales and earnings”
     Russ Robb, Editor, M&A Today

Creating value in the privately held company makes sense whether the owner is considering selling the business, plans on continuing to operate the business, or hopes to have the company remain in the family.  (It is interesting to note that, of the businesses held within the family, only about 30 percent survive the second generation, 11 percent survive the third generation and only 3 percent survive the fourth generation and beyond).

Building value in a company should focus on the following six components:

  • the industry
  • the management
  • products or services
  • customers
  • competitors
  • comparative benchmarks

The Industry – It is difficult, if not impossible, to build value if the business is in a stagnating industry.  One advantage of privately held firms is their ability to shift gears and go into a different direction.  One firm, for example, that made high-volume, low-end canoes shifted to low-volume, high-end lightweight canoes and kayaks to meet new market demands.  This saved the company.

The Management – Building depth in management and creating a succession plan also builds value.  Key employees should have employment contracts and sign non-compete agreements. In situations where there are partners, “buy-sell” agreements should be executed. These arrangements contribute to value.

Products or Services– A single product or service does not build value.  However, if additional or companion products or services can be created, especially if they are non-competitive in price with the primary product or service – then value can be created.

Customers – A broad customer base that is national or international is the key to increasing value.  Localized distribution focused on one or two customers will subtract from value.

Competitors – Being a market leader adds significantly to value, as does a lack of competition.

Comparative Benchmarks – Benchmarks can be used to measure a company against its peers.  The better the results, the greater the value of the company.

Three keys to adding value to a company are: building a top management team coupled with a loyal work force; strategies that are flexible and therefore can be changed in mid-stream; and surrounding the owner/CEO with top advisors and professionals.

What Would Your Business Sell For?

There is the old anecdote about the immigrant who opened his own business in the United States. Like many small business owners, he had his own bookkeeping system. He kept his accounts payable in a cigar box on the left side of his cash register, his daily receipts – cash and credit card receipts – in the cash register, and his invoices and paid bills in a cigar box on the right side of his cash register.

When his youngest son graduated as a CPA, he was appalled by his father’s primitive bookkeeping system. “I don’t know how you can run a business that way,” his son said. “How do you know what your profits are?”

“Well, son,” the father replied, “when I came to this country, I had nothing but the clothes I was wearing. Today, your brother is a doctor, your sister is a lawyer, and you are an accountant. Your mother and I have a nice car, a city house and a place at the beach. We have a good business and everything is paid for. Add that all together, subtract the clothes, and there’s your profit.”

A commonly accepted method to price a small business is to use Seller’s Discretionary Earnings (SDE). The International Business Brokers Association (IBBA) defines SDE as follows:

Discretionary Earnings – The earnings of a business enterprise prior to the following items:

  • income taxes

  • nonrecurring income and expenses

  • non-operating income and expenses

  • depreciation and amortization

  • interest expense or income

  • owner’s total compensation for one owner/operator, after adjusting the total compensation of all other owners to market value

Here are some terms as defined by the IBBA:

  • Owner’s salary – The salary or wages paid to the owner, including related payroll tax burden.

  • Owner’s total compensation – Total of owner’s salary and perquisites.

  • Perquisites – Expenses incurred at the discretion of the owner which are unnecessary to the continued operation of the business.

Developing a Multiplier

Once the SDE has been calculated, a multiplier has to be developed. The following (just as a guideline) should be rated from 0 to 5 with 5 being the highest. For example, if the business is a highly desirable business in the current market, “desirability” would be rated a 4 or 5. If the business is in an industry that is quickly declining or nearly obsolete, “industry” would be given a 0 or 1 rating.

Age: Number of years the seller has owned and operated the business.

  • Terms: Is the seller willing to offer terms?  For example, will the seller accept 40 percent as a down payment with the seller carrying back 60 percent at terms the business can afford while still providing a living for the buyer?
  • Competition: Consider the local market.
  • Risk: Is the business itself risky?
  • Growth trend of the business: Is it up or down?
  • Location/Facilities
  • Desirability: How popular is the business in the current market?
  • Industry: Is the industry itself declining or growing?
  • Type of business: Is the business type easily duplicated?

The average business sells for about 1.8 to 2.5. Obviously, if the SDE is solid and the multiple is above average, the price will be higher. Keep in mind that the price outlined includes all of the assets including fixtures and equipment, goodwill, etc. It does not include real estate or saleable inventory. The price determined above assumes that the business will be delivered to the buyer free and clear of any debt.

Veteran Wisdom

When all else fails, the words of a veteran business broker will work.

Asking Price is what the seller wants.

Selling Price is what the seller gets.

Fair Market Value is the highest price the buyer is willing to pay and the lowest price the seller is willing to accept.

Sellers should keep in mind that the actual price of a small business is about 80 percent of the seller’s asking price.