EBITDA and Factors That Determine Business Valuation Multiples

“Zink: The misconception about multiples”

A quick review of the growing older business owner problem, how to evaluate businesses, what factors determine the multiple used for a realistic business valuation.

Older business owners looking to sell their business:

[As Americans get older so do business owners; this will create a large demand for financed and experienced buyers in the upcoming years. From the article, the May 24, 2019 Kiplinger Letter, Forecasts for Executives and Investors stated, “As America’s population gets older ... many businesses will change hands in the coming years. Just as the workforce is aging, the ranks of business owners are grayer on average. A lot of owners are mulling how and when to sell. A quarter of business owners are over 60, a figure that will grow once all of the members of the baby boom generation reach retirement age. Lots of them intend to sell relatively soon ... as many as half aim to do so in the next five years, according to one recent survey of business owners. But relatively few have an exit plan in place.”]

Metric used to evaluate small to medium sized businesses:

[A business that has scaled, added units, added employees, where the owner becomes dispensable to the business and where profits approach the one-million dollar mark will be sold based on EBITDA, Earnings Before Interest Taxes Depreciation and Amortization.]

Multiples of EBITDA for small businesses:

[These multiples generally start at two times cash flow (EBITDA) but may reach six or seven or higher depending upon factors such as: industry type, profitability, top line and bottom line growth, sound financials, market share, position in the market, number of competitors, barriers to entry, competitive advantage including monopoly, proprietary technology, recurring revenue streams, repeat and diversified customers, fast growing, reliability of annual earnings, increasing pipeline of new business, excellent service, quality and tenure of the management team, loyal employees, minimal dependency on the owner or any of the key employees or vendors or customers, intellectual property, and on and on.]

Number of Young Entrepreneurs Declining

The Wall Street Journal has labeled young entrepreneurs an “endangered species.” This is a serious problem because older entrepreneurs are retiring or shutting their business down at a record pace.

The wave of retiring baby boomers who own closely held private businesses will need to sell their companies, transition them to a new generation of owners -- or risk shutting them down, cutting jobs in the process.

According to project-equity.org, baby boomers own almost half of all privately-held businesses. Small businesses are the lifeblood of our economy, as they make up 99.7% of all firms and provide 48% of all jobs in the United States.

The article below details why there are fewer young entrepreneurs, this means there will be a strong demand for strong young operators from firms like GTE.

How Private Companies are Valued

Private company valuation follows a significantly different procedure compared to public company valuation. The value of public companies is simply calculated as the product of its stock price and number of shares outstanding. For valuing private companies, on the other hand, there are three common methods that use publicly available data.

Method 1: Comparable Company Analysis (CCA)

The CCA method uses a key assumption that similar businesses in the same industry have similar multiples. When the private company’s financials are not publicly available, one must search for similar companies and use their multiples to determine the target firm’s value.

The first step is to identify key characteristics of the target firm, such as size and industry, and then compile a list of companies that share those traits. One can then take each company’s multiple and calculate the industry average.

The firm is then valued as follows:

Value of target firm = Multiple (M) x EBITDA of target firm,

where the Multiple (M) is the average of Enterprise Value / EBITDA of comparable firms

Note: The EBITDA of the target firm is typically projected for the next 12 months.

Method 2: Discounted Cash Flow (DCF) Method

The DCF method starts takes the CCA method one-step further. One must start by determining the applicable revenue growth rate for the target firm which is the average of comparable firms’ growth rates. One must then make projections of the firm’s revenue, operating expenses, taxes, etc. and generate Free Cash Flows (FCF) of the target firm, typically for 5 years. 

Free Cash Flow is calculated as follows:

FCF = EBIT x (1 - Tax Rate) + Depreciation + Amortization - Change in Net Working Capital - Capital Expenditure

The firm’s Weighted Average Cost of Capital (WACC) is typically used as the appropriate discount rate. To derive WACC, one must know the firm’s cost of equity, cost of debt, tax rate, and capital structure. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM), while the firm’s beta is estimated using the industry average beta. Once one has the weights of both debt and equity, cost of debt, and cost of equity, one can derive the WACC. The target firm is finally valued by summing the FCFs once they are discounted to the present value.

Method 3: First Chicago Method

The First Chicago Method is a combination of the first two methods discussed. What is unique about this method, however, is that it takes into consideration various scenarios of the target firm’s payoffs. This method typically constructs three scenarios: best-case (as stated in the firm’s business plan), a base-case (most likely scenario), and a worst-case scenario. Each case is then assigned a probability.

The same approach as the first two methods is then applied to project cash flows and growth rates for a five-year forecast period for the specific cases. The valuation of each case is derived using the DCF method. Finally, the target firm is valued by taking the probability-weighted average of the three scenarios. This valuation method is often used as it incorporates the firm’s upside potential and downside risk.

Exit Strategies for Your Business

The article from Entrepreneur lists numerous exit strategies for entrepreneurs, an aspect most business owners forget about while they are running a business. Whether you are planning to sell or not, you should always consider your available options throughout your time at the company.

Method 1: The Modified Nike Maneuver: Just Take It 

One of the most popular exit strategies is the ”Modified Nike Maneuver,” which means to use the majority of income to pay yourself a generous salary and bonus instead of reinvesting money in growing your own business. Expanding the scale of operation of your own business would require taking money out of your pocket upfront, which could be problematic if your business requires reinvesting to grow. However, if you have other investors in your company, taking too much money out of the company for your personal use would also upset them as they are looking for rapid growth in their investment. 

Method 2: Liquidation

The second exit strategy is liquidation. In this strategy, you quit your business and sell all of your assets. The proceeds from the sale would go first go to pay back creditors and the remainder would get divided among the shareholders. The main advantage of liquidation is that the process is fairly simple as there is no negotiation or transfer of control involved; however, your assets would only be sold less or equal to market value and the valuable relationships made in the business may go away upon liquidation. 

Method 3: Selling to a Friendly Buyer 

Business owners get emotionally attached to their business over time, so it is often easier to hand their business to someone they know who shares the same passion for the industry. This could create a win-win situation for everyone involved; however, selling to a friend or family member could also tear the company apart when they put emotion ahead of the needs of the business. 

Method 4: The Acquisition

In an acquisition, you negotiate the price based on the perceived value of your business rather than the relative value to the industry. With the right acquirer, the value of your business could greatly exceed the reasonable value based on your income. If you want to choose acquisition as your exit strategy, it is important that you make yourself attractive to the buyer. 

Method 5: The IPO

Initial Public Offering (IPO) is the process of offering shares of a public company to the public in a new stock issuance, allowing private companies to raise capital from the public instead of depending on current investors. Although the IPO could be tempting as it would drastically increase publicity and the stock’s worth, the amount of time and complexities involved with the IPO process makes it rare and a pain in the backside to deal with. Therefore, for most private business owners, it should only be considered as one of the many exit strategies when there are not other ways to get value out of your company without the complexities and efforts involved with an IPO.

For more information check out the Entrepreneur article listed below:


2019 Business Trends

Today’s business landscape is continuously changing, with the introduction of industry-disrupting companies, tech unicorns, and private equity giants dominating markets. These companies are testing the waters in new markets, and figuring out how to navigate consumer and industry trends. One consumer trend is an increased demand for privacy. In a world with constant targeted ads and data breaches, consumers are increasingly aware of how their data is being used. As a result, lawmakers have increased data protection regulations through the Federal Trade Commission to match consumer sentiment. Data mining is still a hot button issue, and lawmakers and consumers are watching to see the extent of how it is being used.

Perhaps the most apparent example of data mining is Alphabet’s plan to build a ‘smart city.’ Alphabet, the parent company of Google, wants to collect data in a Toronto neighborhood to optimize how the city functions. The data collected would include energy use, traffic patterns, and building usage. Many Toronto residents oppose this plan due to privacy concerns. Other companies, such as Apple, have taken extra steps to protect their customers’ data. One example is Apple’s restriction on third parties’ ability to collect data on Apple users. Apple’s secure network is one of its competitive advantages that helps them attract customers. 

Another consumer trend is corporate social responsibility. Companies today rely on good deeds and giving back to the community in order to receive positive PR. There have been countless examples of this in 2019. Amazon is a great example, as they are spending $700 million to retrain many employees to work in fields such as logistics coordination and software engineering. This training will allow employees to move up in Amazon’s corporate ranks, as well as build the skills necessary to launch successful careers outside of Amazon. Lego is another company that has taken steps toward corporate social responsibility. The Danish company started to use plant-based plastics instead of regular plastic in an attempt to be more eco-friendly. Lego has also promised to protect their employees by following fair labor practices. These are just two companies that have learned the importance of CSR in today’s market.

As industry landscapes change, businesses must adjust accordingly. When it comes to privacy, firms are raising concerns among consumers and lawmakers, and we are likely to see increased regulation and more consumer skepticism as time goes on. On the other hand, many companies have learned that doing good deeds is an excellent way to help boost sales.

For more information on 2019 trends and patterns, check out the Entrepreneur article listed below:


Why to Consider Selling to a Young Entrepreneur

Over half of today’s small business owners are baby boomers and many of them are now nearing retirement without a tangible plan regarding who will take over the business. An increasingly popular choice is entrepreneurship through acquisition (EtA) or search funds, through which an individual or group works with investors to evaluate, negotiate, and close on the purchase of a business that they will own and manage, without using any of their own money.

Search funds have increased in popularity because they offer young and energetic entrepreneurs the unique opportunity to have a more involved CEO role, rather than the more traditional positions available post-MBA. Essentially, search funds offer aspiring entrepreneurs the opportunity to step into a CEO role at an early age and have partial ownership of a business. That being said, however, there is a risk-return tradeoff to consider as the searcher faces the opportunity cost of losing two to three years of professional development while they look for a business to purchase. There is also the chance that the entrepreneur won’t find any business to acquire at all and will then have to change their career path again.

For business owners, there are benefits to selling your business to a young entrepreneur. Entrepreneurs commit to moving to and operating that one business that they acquire for the long term. These entrepreneurs understand the financial opportunity that comes with owning a business, but also the risk; that is why they look for strong businesses where they can rely on the employees, culture, and practices. These entrepreneurs carry on an owner’s legacy, bringing their passion and energy to the business they acquire.

EtA creates an exciting opportunity for both entrepreneurs and owners. It allows owners to leave behind their company and its legacy in the hands of a young entrepreneur ready to take on a new leadership role.

Hiring a Broker When Selling Your Company

Once a business owner has decided to sell their business, there are a number of factors to consider. One of the biggest questions is whether to hire a broker to assist with the sale. There are pros and cons to using a broker, but ultimately the answer is situation-dependent. A broker is a professional who normally specializes in valuing and selling businesses.Most business owners are experts in their industry, but they know very little about mergers and acquisitions.

Not all brokers are qualified or certified like a lawyer or an accountant. The best brokers and Investment Bankers focus on deals around $5M EBITDA and up; the brokers who focus on deals smaller than that can be less sophisticated. Also, brokers typically get paid a percentage of the selling price, so they may ruin a deal by giving bad advice to a business owner just because they are looking for the highest possible payout on the sale and not necessarily on the happiest outcome for the seller.

Owners often hire brokers because selling a business requires a sustained effort, one that brokers can assist with, allowing the owner to remain focused on running the business. The most effective brokers will be willing to provide work samples and client referrals and will take the time to learn about the business for sale and give owners a realistic idea of the valuation. They will also ask detailed questions about the business so they are prepared to answer interested buyers’ questions.

Our suggestion is for owners to meet with and compare multiple brokers, accountants, and lawyers and ask them about their prior experiences in order to find a good fit for the type and size of their company. Working with a trusted intermediary can help owners logically work through an often emotional process and secure the highest payout, while also maintaining the legacy and continuity of the business.

EBITDA Multiples

Selling a business is difficult on an emotional and financial level. Not only do business owners have to find a good match in terms of meeting a buyer who will continue their legacy, but they must also use appropriate metrics to value their company. There are many factors to consider including competitive advantages, growth opportunities, and historical financial performance.

Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a great starting point to understand how to measure financial performance. It is calculated by adding non-cash expenses back to the operating income and is used as a proxy for evaluating a business’ earning potential. Essentially, EBITDA creates a standard measure of performance, making it possible to compare similar companies across industries or in different tax brackets.

Typically companies with EBITDA of $3M and under are considered to be in a 3-5x multiple range. For example, a $1M EBITDA company would be valued at $3M - $5M dependent upon a number of other factors. Some examples of common factors are key person risk, cyclicality, and customer concentration, among others. The higher the EBITDA gets the higher the multiple range gets, so a $5M EBITDA company would be more likely to sell in the 5-7x multiple range.

Business owners should work to boost their overall financial performance, create consistent earnings, prepare high-quality financial statements. Working with an accountant and your financial team now can help your value when you are ready to sell down the road. If businesses are typically value based on EBITDA, it is important to understand the metric and how you can prepare to increase your value by using it.

Staying on Top of the Estate Planning Process

The article from the Financial Review details the importance of establishing a finalized estate plan. This legal document details the process for how an individual’s assets will be preserved, managed, and distributed after death. Whether you are a homeowner or a small business owner, the creation of a thoughtful plan is crucial to the protection of your financial portfolio. Much of the estate planning process is needed to help avoid sticky legal and family issues that could potentially arise from an unforeseen death. For many business owners, creating an estate plan is an important piece of preserving wealth for future generations.

The estate planning process can potentially become a very complex situation when the transfer of a business is involved. This effort to create a plan for the future can be derailed from severe infighting between trustees.A potential solution to this problem is the creation of a will. This legal document is a set of instructions that details the individuals whom are responsible for assuming control of the business. Despite many of these troubles, owners should recognize the need to properly forge out a plan that best prepares the transfer of their business on to the next generation. 

Another consideration many owners should take when creating an estate plan is how much control they wish to retain after death. The desire to maintain control of the business requires a formal legal plan to be laid out with an attorney. Owners must decide which restrictions to place upon the important decisions of the enterprise. Such limitations are required to prevent the occurrence of dangerous risk factors such as marriage breakdowns, bankruptcy, and spendthrift beneficiaries. Some of these dangerous elements can be mitigated through electing an independent advisor to the oversight of the estate plan. These succession efforts are the best avenues towards preserving the longevity of your business.

Seven Value Creation Lessons from Private Equity

Private equity firms enjoy a number of advantages when it comes to building high-growth businesses and they can implement the following strategies to build a value creation regimen.

First, for continuous investment from partners, private equity firms must focus on value creation that extends beyond simple financial engineering and cost-cutting. PE firms focus on investing in core operations to reduce extraneous costs, and carefully choose, and exit, companies based on the available potential to create value. 

The next strategy is to understand the importance of cash. PE firms typically finance 60 to 80% of an acquisition with debt, creating a sense of urgency to generate cash. To improve cash flow, firms tightly manage receivables/payables, reduce inventories, and scrutinize discretionary expenses. To preserve cash, they invest only in opportunities that contribute significant value and delay the other options. 

Third is to operate as though time is money. PE firms must be proactive and deliberate in their actions during the first few months of ownership of portfolio companies. 

The fourth tip is to apply a long-term lens. The best PE firms not only cut costs but also invest in the highest-potential ideas for creating core value in their portfolio companies. These decisions come only after rigorous analysis and thoughtful debate. 

Another key suggestion is to work with the right team. PE partners understand that strong, effective leadership is critical to their investment’s success. A third of portfolio company CEOs exit in the first 100 days and two-thirds are replaced during the first four years. To put the right CEO and management team in place, PE firms may draw on their own in-house experts or external network.

Sixth is to link pay with performance. Companies can foster a high-performance culture by strengthening individual performance measures and incentives to align them with value creation. They must first reform the performance review process so it distinguishes and rewards talent.

Finally, firms must set clear, optimistic goals in critical areas and tie them directly to compensation. Long-term aspirations should drive specific initiatives with explicit objectives, and, in turn, the financial implications of these initiations should drive annual plans and budgets.

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