The Basics of Valuation

The two primary methods to value a middle-market business include:

1. Multiple of EBITDA: Multiply the earnings before interest, taxes, depreciation, and amortization (EBITDA) of the business by a multiple. Common multiples for mid-sized businesses in the middle market are four to eight times EBITDA. 
2. Comparable Sales Approach: This involves researching prices of similar businesses that have sold and then adjusting the value based on any differences between your company and the comparable company.

Profit is the #1 criteria buyers look for when buying a business and the #1 factor that buyers use to value a business. 

Method 1: Multiple of EBITDA

Here’s how you can value your business using the multiple-of-EBITDA method:

Step 1: Determine your EBITDA for the previous 12 months or your latest fiscal year. This is called “recasting” or “normalizing” your financial statements. It involves adding the following back to the net profit of your business – depreciation, amortization, owner’s salary, non-cash expenses, non-recurring expenses, and other perks.

Step 2: Multiply your business’s EBITDA by the multiple.

Example: $5 million EBITDA x 6.0 multiple = $30 million value of business

Common Multiples

Here are common multiples for mid-sized businesses:

• Construction Businesses: 3 to 7 times EBITDA
• Food Businesses: 4 to 7 times EBITDA
• Manufacturing Businesses: 4 to 8 or more times EBITDA
• Retail Businesses: 4 to 6 times EBITDA
• Service Businesses: 4 to 7 times EBITDA
• Wholesale Businesses: 4 to 6 times EBITDA

Multiples vary with the current economic climate and market conditions and also with the desirability of the business. The multiple varies based primarily on the industry in which a business operates in addition to several other factors. 

How do you determine the appropriate multiple? The best source is experience such as the expertise you can gain from an investment banker with significant experience in the industry. Other than that, several databases are available that provide pricing information on businesses. This information can help paint a picture, though the picture will be incomplete, at best. Some of these databases require subscriptions costing up to tens of thousands of dollars per year. If you’re in the dark, I recommend reaching out to an M&A advisor or investment banker to ask if they have the current multiples for your industry.

Larger businesses always sell at higher multiples. To demonstrate:

• Business A: EBITDA of $1 million per year = 4.0 multiple, or a value of $4 million.
• Business B: EBITDA of $5 million per year = 5.0 multiple, or a value of $25 million.
• Business C: EBITDA of $100 million per year = 8.0 multiple, or a value of $800 million.

The relationship between EBITDA and multiples is direct. As the EBITDA of a business increases, so does its multiple. Larger businesses are seen as more valuable by sophisticated investors because they’re viewed as more stable, have more professional management teams, and are less dependent on the owner for the business to operate. There’s a simple, clear relationship between the size of a company and its multiple that’s demonstrated in the transactional databases and widely accepted by both investment bankers and buyers.

Method 2: Comparable Sales Approach

The comparable sales approach is a method for valuing your business based on the prices of similar businesses that have sold, then making adjustments to account for any differences between your company (i.e., the subject company) and the comparable company.

This approach is often difficult to use because pricing information on privately held businesses is difficult to obtain. The best source of comparable transactions is from an M&A intermediary or business appraiser who has access to these private databases. Several databases are available that contain comparable business sales. However, the information is sparse or incomplete, so you can’t rely on this data entirely. Collectively, these databases contain approximately 100,000 transactions.

Other Factors to Consider

Beyond valuing your business by EBITDA or comparable sales, there are other factors to take into consideration.

Value Enhancement

Remember, there are only two ways to directly increase the value of your business:

1. Increase EBITDA:
   • Reduce expenses.
   • Increase revenues.
2. Increase the Multiple:
   • Reduce the perception of risk.
   • Improve the perception of potential returns.

Your multiple is a reflection of how risky a buyer perceives your business to be, and how much opportunity your business presents. To increase your multiple – and your valuation – take steps to reduce the risks associated with your business, and present a growth plan to the buyer that demonstrates the growth potential in your business. Buyers will pay higher multiples for companies that represent less risk and that have more growth potential.

Accounting for Synergies

The valuation methods mentioned above don’t take into account the possible synergies that might be achieved. There are five broad types of synergies: 

• Cost savings
• Revenue enhancement
• Process improvements
• Financial engineering
• Tax benefits

The value of synergies is impossible to calculate without knowing who the buyer is and having access to their financial statements. The value of synergies is different for every buyer; therefore, the value of your business can differ substantially depending on the buyer. If you expect to sell your business to a strategic buyer, the best you can do is to estimate the baseline value (i.e., fair market value), and then attempt to maximize the price as much as possible by negotiating with multiple buyers.

What’s Included in the Price

The price should include all tangible and intangible assets used in your business to generate the cash flow, or EBITDA, that your business produces. This includes all of the equipment and assets required to operate your business on a daily basis, and the amount of working capital required to sustain your current revenue.

Working capital is defined as:

• Current Assets: Accounts receivable, inventory, and prepaid expenses, minus 
• Current Liabilities: Accounts payable, short-term debt, and accrued expenses 

Working capital is customarily included in the value of nearly all middle-market companies.

The value of your business can differ substantially depending on who the buyer is.