Understanding Valuation
Business valuation is cryptic, open to unlimited interpretation, and far more of an art than any type of science. If you understand the puts and takes of what goes into arriving at a business valuation, then you will have a better chance of smoothly working through the valuation process with your broker when you prepare to list your business for sale. In turn, you will be better equipped to respond to offers when they arrive.
The most commonly used reference point for valuations is a multiple. If you’ve ever bought a stock then you have probably heard of PE, or price to earnings ratios. This is a simple concept: divide a stock’s price by the company’s earnings number (assuming you already know what this number is) and you’re done. All you do is compare these numbers to the PE numbers of other companies for sale, and you know if you are in the right ballpark for a valuation. Simple, right?
In private company acquisition parlance, a commonly used metric is an EBITDA multiple. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. For example, if you are asking $100 for your company and your EBITDA is $2.50, your EBITDA multiple is 4x ($10 ÷ $2.50 = $4). In our opinion, EBITDA is not a terribly great number, especially for capital-intensive companies with heavy capital expenditures. In our experience, EBITDA numbers never really decline—making EBITDA a terrible proxy for cash flow over the long-term. Moreover, multiples don’t account for specific elements of your business such as working capital, margins, and leverage. Every business is unique, and multiples can too often condense numbers down too far to be useful, resulting in a poor translation of value.
In addition, there are the numerous intangible features of a business that have value, that are often not translatable into numbers at all. Think about how your business operates. There is a person on your staff who shows up every day ready to motivate, problem solve, and support others. This person holds your most important team together, and positively impacts your entire company. Provided that your business sale goes smoothly and the business is transferred to a buyer who offers a comparable or an elevated working environment, salary, benefits, etc., this employee will most likely be transferred along with the sale. The employee in question earns a salary on par with other workers in similar positions across various companies, but his output is far greater and more integral to your business than his salary reflects.
The same conundrum can be apparent when it comes to placing a value on an intangible like greater company culture. Your stated business hours may be 9-5, but if your workplace is laced with drama and disaffection at the core of its culture, the cost to the owner could be another 10 or 20 hours per week of stress, anxiety, and cleaning up relational messes. On the other hand, a company with a cohesive culture that empowers employees and helps them feel that they are valued and doing meaningful work will be a far easier company for a leader to run. If your buyer is planning to actively run the company herself, then there is an associated value that corresponds to the ease of assuming charge. Free time without stress, feeling like you are providing your employees with real purpose, and showing up to work in a positive environment are certainly factors that might compel a buyer to pay a premium for your business. That is, provided that your buyer is able to recognize this asset in their review of your business—and that the buyer simultaneously places value on this type of asset.
The examination of intangibles segue ways to the consideration that different buyers have diverse priorities when looking to acquire a business. There are numerous kinds of buyers: private equity firms, investment firms, solopreneurs, and holding firms, such as us here at Palindrome LLP. All of these investors naturally have their own set of criteria for what makes an appealing business acquisition. For all of the years that we have spent in the investment sector, we have never encounter a business buyer who didn’t care about the balance sheet! However, if the financials are sound, there are many more factors on which buyers may place greater or lesser importance. Even if your buyer does not plan to run the company personally, an experienced buyer will understand the value of intangibles like company culture for the long-term consistent success of a business. This is why it is important not to focus solely on multiples like EBITDA when completing your valuation process.
“If your broker is doing their job, they will undoubtedly obtain other valuations besides the one indicated by EBITDA.”
If your broker is doing their job, they will undoubtedly obtain other valuations besides the one indicated by EBITDA. These will include discounted cash flows and some relative valuations. The broker will calculate these valuations by using recent transactions as a comparable. Make sure you obtain a range of valuations, and understand why an offer to buy your business may come in low relative to your expectations (cyclically low margins, high leverage, etc.).
Part of your due diligence in the valuation process will be to convey to your broker what intangible assets might hold value for your target buyers. Make sure your broker highlights these features side-by-side with the standard business valuation metrics. As a result, your listing will appeal to a higher caliber of investor who cares about and is willing to pay a premium for the comprehensive package of your business’s assets, and not exclusively the monetary bottom line on a facts and figures sheet.
