I am often asked about valuation trends by business owners seeking to have their business valued for a variety of reasons from planning for ownership transition to contemplating selling their business. If you have read Cashman’s Comments before you know that I distrust earnings multiples in general, however they are useful as a sanity check when looking at the value of a particular business.
The Alliance of Merger & Acquisition Advisors has complied information from their members on nearly 700 business sale and recapitalization transactions in the lower middle market. The lower middle market is comprised of firms with an annual revenue generally in the range of $5 million to $50 million.
The Deal Multiples
82% of transactions were completed at less than a 7 multiple. There is a better than even chance that any random company in these size ranges will sell in the range of 3 to 6x EBITDA. There’s a 70% chance that it will sell for less than 6x EBITDA, and over an 80% chance that it will sell for less than 7x EBITDA.
This may run contrary to what you have heard about the market. Owners who believe their business should be worth a much higher multiple sometimes challenge us. Sometimes this is based on a multiple of sales, often 2-3 times. However, 44% of deals were less than $5M while 34% of companies had sales less than $5M. If a lot of transactions were being done at a multiple of even 2 times sales we should see a cluster of sales between $7 and $50 million, which we clearly do not. A far better measure of transaction size will be cash flow, of which EBITDA is a proxy measurement.
Effect of Deal Size on Multiple
The size and makeup of a transaction can also affect the EBITDA multiplier it receives in a transaction. All things being equal a larger company drive a larger deal, and will receive a higher EBITDA for a number of reasons:
- Larger transactions tend to be more strategic;
- Larger transactions may involve more creative financing structures that allow companies to disburse risk;
- There is often more synergy involved in a large transaction. If there is a large amount of duplicate overhead a company may be able to save significant amounts by combining and eliminating;
- The quality of earnings is often greater in larger companies. Typically a large company’s financial statements have been assembled by a team of professional accountants and CPA’s and may have been audited. This means that buyers and financiers will rely more on that company’s financial statements than they will on a smaller company.
You can see this same relationship below when we compare EBITDA multiples to revenue. There is a clear trend toward higher multiples for larger companies for much the same reasons as discussed above.
Drivers of High Multiples
Valuation multiples are usually driven by risk. The lower the perceived risk, the higher the cash flow multipliers that company will receive. Our job then is to figure out how we can reduce the risk factors that buyers of your business, internal or external would perceive.
Here are some risk factors, other than scale, that we might want to work on in your business:
- Quality of your financials. If you have been writing off every expense you can think of to beat the tax man, you will want to stop doing so years before you want to sell. Buyers are very leery of sellers with a lot of adjustments they want to make to their financials in order to show a “true” position.
- Trends. Buyers will pay close attention to various trends in your business. Have your sales been rising or falling over the last several years? What has been going on with your key financial ratios? Has cash flow been increasing or decreasing? Have you been experiencing the right amount of employee turnover?
- Your Industry and Your Place In It. You cannot control the industry in which you compete. If you have been making buggy whips, it won’t matter how successful you were at doing it. On the other hand, if you are in a hot industry, your EBITDA multiple may be very high simply because you are there. You need to be sure that you compare favorably to whatever industry you compete in to minimize the unavoidable impact your industry may have on the value of your business.
- Management Quality. Can your business run without you? If so, the perceived risk to the next owner will be much lower. If not, you should plan to stick around for an extended period to insure a buyer that the relationships and knowledge that you hold will be available to them.
- The Economy. Much like your industry, the economy has an effect on multiples. Rising interest rates tend to be a drag on buyers that want to finance purchases. A strong economy tend to make many buyers more aggressive about acquisitions. Tax policy can also influence how much cash flow a buyer is willing to count in arriving at a valuation.
- Customer/Supplier Concentrations. More than any other single business factor I have experienced, this one stops many transactions, or significantly devalues them. Business owners often feel that being closely tied to a large, industry leader makes them more valuable. Buyers see the opposite, regardless of whom that tie is to. They see the potential for the entire business to vanish if that key customer or supplier stops doing business with them.
- Deal Structure. How a transaction is structured can have a large impact on a multiple. If a buyer is able to leverage a transaction via seller financing he can use less of his own equity and will generally pay a higher multiple for the same business. Other structures can have a similar effect.
Know the trends that have the most impact on what your company can get, based on industry, size and metric used. If you work on the drivers that influence valuation, you can make your business more attractive to the next generation of ownership.