We examine one of the principal quantitative factors that potential acquirers use to value small to medium businesses
There are many factors that a potential acquirer will consider when valuing a business for sale. However, the most common valuation method used for small to medium businesses is to apply a multiple to the adjusted EBITDA to determine the final sales price.
EBITDA is your business’ net income excluding interest, taxes, depreciation, and amortization. Adjustments, often referred to as “addbacks”, are then applied to EBITDA to retroactively remove the impacts of any extraordinary expenses not expected to recur after the sale. This may include executive compensation or owner distributions that the new ownership is not expected to sustain on a continuing basis.
We now turn our focus to the valuation multiple. It can be viewed conceptually as a “black box” that accounts for a broad variety of issues and concerns. At its core, the valuation multiple is a simple way of effectively estimating the present value of future expected cash flows generated by the business. This multiple value is strongly tied to the industry area that the business operates in.
Because valuation multiples depend so much on the company’s industry, owners don’t have strong control over it. However, it’s fair to say that valuation multiples can vary (sometimes widely) even within the same industry, which means that some businesses are sold for above average multiples while others receive below average valuation. Even a small change in the valuation multiple can be significant, particularly for an individual entrepreneur seeking a lucrative exit.
Clearly, the best way to maximize the value of your business is to increase EBITDA. However, there are other things you can do to make your business more attractive to a potential acquirer. Understand that, like beauty, the attractiveness of an acquisition target is in the eyes of the beholder. Maximizing it is therefore more of an art than a science. However, one generalization we can make is that anything we can do to increase the potential acquirer’s confidence in his ability to profitably manage the business will most likely cause him to feel more comfortable in consummating the sale, perhaps at a slightly higher multiple. Minimizing operational uncertainty is therefore key.
Please keep your eyes on this space for our next article that will explore what can be done to prepare a business for sale in a way that maximizes EBITDA and nurtures the confidence that a potential acquirer feels when contemplating the acquisition of your business. Doing so will help cover all your bases when attempting to maximize your business’ valuation.