How to determine the value of a business? While there is a simple formula for business valuation that involves multiplying EBITDA by a multiple to arrive at an enterprise value, the determination of the multiple can be more complex.
EBITDA x Multiple = Enterprise Value
EBITDA and various adjustments to it is relatively straightforward and we have talked about it before (see blog post), but what about the multiple? What is the multiple range? Do revenue multiples matter? How are they impacted? What causes multiple expansion (or the reverse – multiple compression)?
Let’s look at what they are and why they matter. Compare the impact on the same business with different multiples:
As you can see, the same business generating the same EBITDA using different multiples can have a very large impact on business value.
The multiple ranges are 2x to 6x of EBITDA for traditional service, manufacturing, and retail businesses. There are several factors that can impact the multiple that should be used. Here are a few:
- Size of EBITDA
The size of the business and thus EBITDA, impacts the multiple. This is because of perceived risk. A larger business is perceived to be stronger and able to better withstand volatility in the market. Businesses with EBITDA over $1m have much greater multiples that those under $1m. This greatly impacts business value.
- Type of Revenue
All buyers put a premium on stable, predictable, reoccurring revenue. Again, this has to do with risk management. If the revenue is subscription or contractual in nature it is much more stable than revenue where each sale is project or transaction based. That is why technology companies have multiples of revenue and not EBITDA. To the extent you can move to some type of subscription or contractual model, this will greatly enhance your business value.
- Type of Buyer
There are three basic groups of buyers:
- Strategic (competitors or firms similar to your business)
- Financial (Private Equity, Family Offices or passive owners)
- Owner / Operator (someone that will be involved in day-to-day running of company)
What each group is willing to pay and the multiple they’ll use will be dependent upon operational synergies they can leverage and financing that will be required.
- Sustainability of Revenue Growth
How a business acquires clients is very important. Consider these three examples:
- Word of mouth and based upon the owner’s contacts
- Small sales team calling on new accounts
- Front page SEO placement of top keywords with steady, regular lead flow
Obviously, there is a dramatic difference in the three. We have seen cases when business value have seen their value dramatically increase due to their lead generation and revenue growth strategy.
- Competitive Advantages
Warren Buffett and Jim Collins talk about “building a moat around your business”. Moats work in one of two ways:
- Make it difficult for competitors to get in
- Customers have difficulty getting out
Anytime you develop a special niche of products or services where you have few competitors and are able to dominate in your market, your business will more valuable.
- Client Diversification
Having a large diverse client base where no client is over 20% of revenue is critical. Again, it is about managing risk. This will protect you from having a customer that puts too many demands on the business value. It also mitigates the impact that losing a client like this could have on your business. Achieving a wide and diverse customer base could require diverse strategies of client acquisition.
- High Gross Profit Margin
Gross profit margin is the most basic measure of a company’s profitability: how much money is left after accounting for the cost of labor, raw materials and other supplies required to produce the product or service. While SG&A (sales, general, and administrative expenses) may vary significantly from owner to owner, the cost of goods should remain consistent. Therefore, a business with a higher gross margin (particularly when compared to industry averages) will command higher multiples.
- Management Team Depth
This one can be difficult. One of the hardest things a business owner must do is to let go of critical functions in the business. To accomplish this, you must develop a management team that you trust, empower them, put processes in place, automate where possible, and reduce the time you spend in the business. That is correct – begin to step away. Gradually at first, then more and more.
The process begins with getting an initial valuation and this is where Brentwood Growth can assist. From there you can determine if you are ready to sell your business or wait and grow the value. Brentwood Growth can help you look at each of these and put strategies in place not only to increase the EBITDA, but to also get a higher multiple, and therefore higher valuation for your business.