Why Valuation is the Most Underrated Metric for Lower-Middle Market Businesses

Most people know the value of their retirement portfolio. If not, they can quickly ask their financial planner.

Most people know the value of their home. If not, they can quickly Google their address and a valuation is delivered.

Ask a Business Owner if they know the valuation of their business and virtually no business owner knows. Despite most business owners having 85% of the wealth invested in their business, only 2% of business owners know their valuation.

It’s not a huge leap to believe that a Business Owner’s business is their most valuable asset. So, why isn’t valuation being tracked?

Perhaps it’s because Business Owners view their business as annual income instead of an asset. Perhaps they have an idea in their head of their business’s valuation? Perhaps they believe it’s too complicated to calculate.

We believe not knowing your business’s valuation, not tracking it over time, and not implementing measures to increase valuation is one of the biggest mistakes a small to medium sized Business Owner can make.

Additionally, at some point, most business owners will want to exit their business. Even if they grant the business to a family member, the Business Owner should understand it’s fair market value.

First, Is Your Business Transactable?

It may not sound like an obvious question, but the reality is 80% of businesses do not sell or have an exit. Therefore, the first step in valuation is to know if you have a sellable business or not.

Primary Reasons Why Your Business May Not Sell

• Your business too small

• There are keyman issues, meaning, if you remove the Owner the business cannot function on its own. A nicer way to say this is the Business is You

• Poor / Unclean financials

• Declining performance

If you answer is yes to one or more of these reasons, you have work to do prior to valuing your business. It can be overcome, but these reasons are non-starters for most Buyers.

How to Value Your Business

Businesses are valued by multiplying EBITDA (or Operating Profit) times a multiple of earnings.

EBITDA x Multiple of Earnings = Valuation

EBITDA is mostly straightforward. You look at your P&L (Profit and Loss Statement) and reference your EBITDA. We say mostly straightforward because most Buyers won’t solely look at last year’s performance or a trailing 12 month performance, they are likely to average the past three years of EBITDA. Or, if the business has declining EBITDA, only the past 12 months may be used.

Multiple of Earnings is calculated by assessing both risk and growth opportunities.

First, the potential buyer will perform a market comp on the business. Similar to real estate, where cost per square foot is assessed based on recent transactions in your area, multiples of sale are comped by like businesses that have recently transacted. This gives Buyers a multiple of sale baseline.

From there, the baseline is adjusted for risk and growth opportunities.

For example, if the company has a large and diversified customer base with consistent recurring revenue, the multiple of earnings will be higher because there is less risk of revenue erosion. If the opposite is true and the company has a small customer base with revenue concentrated amongst just a few clients, the multiple of earnings will be lower because of the risk.

If the business can operate and generate sales without a key central person, the multiple of earnings is increase. If there are keyman issues, the multiple of earnings is decreased.

If the company has strong operating practices that can be leveraged for growth, the multiple of sale is increased. If the business has limited operating processes, the sale multiple is decreased.

The increases and decreases to multiples of earnings can be drastic and can have material impact on valuation.

Valuation Examples

In our simple valuation example, we’ll look at three companies, all with an identical EBITDA over trailing 12 months of $2.0M. The industry is agnostic for this exercise. Comps for the industry reflect a sale multiple of 4.0x.

Company 1 is the baseline example. EBITDA has been consistent for the past three years. Therefore, $2,000,000 EBITDA x a 4.0 multiple of sale = $8,000,000 valuation.

Company 2 is the discounted example.

• EBITDA trend has declined over the past five years, even though there was a record year two years ago. Weak EBITDA outlook leads to the baseline multiple of 4.0 decreasing 0.5 points to 3.5

• The owner is heavily involved in the business and a full transition will be required. The multiple is reduced another 0.5 points to 3.0

• The business lacks operational rigor meaning the buyer will need to install management system to enable growth. The multiple is further reduced another 0.5 point to 2.5

• The final valuation is $2,000,000 EBITDA x a 2.5 multiple of sale = $5,000,000

Company 3 is the increased example.

• EBITDA trend has increased over the past three years with the company growing 20% year over year. The baseline multiple of 4.0 increases 0.5 to 4.5

• The Owner is still involved with sales for the largest accounts, but the business has installed a management team. The Owner spends most of their time on business strategy. The multiple is increased another 0.5 points to 5.0.

• The business has operational rigor and is poised for additional scale and growth. The multiple is further increased another 0.5 points to 5.5

The final valuation is $2,000,000 EBITDA x a 5.5 multiple of sale = $11,000,000

While these examples are overly simplified, the difference between company 3 and company 2 is $6,000,000 and company 3’s valuation is more than double company 2.

Why Valuing Your Business Early Pays Dividends

Let’s revert to the retirement portfolio analogy. Financial Planners will consistently tell their clients two things. First, the earlier you start investing, the more your money works for you because of compound interest. Second, save more. The more you save early, the more you’ll have to retire, and the more interest will compound your money. And lastly, the more you use tools to plan for your retirement, you can see your portfolio’s valuation, if you are on track, and if there is a shortfall, what types of actions you may need to take.

Planning for your business’s exit is no different. The earlier you understand your business’s current valuation, the earlier you have the opportunity to make improvements to increase the valuation. And, if you understand the levers to increase valuation; Increase EBITDA, reduce risk, add scalable processes, you can focus on ROI driven initiatives to increase your business’s valuation. You can also track your business’s valuation to understand growth overtime.

With one to two years, you can make a lot of positive changes. With ten years of planning, you can be very purposeful in valuation planning to ensure your exit’s best financial outcome.

Why Valuing Your Business Enables Leverage During Exit Negotiations

The final point of why valuation is the most underrated metrics for small to medium sized businesses is because is enables leverage during exit negotiations with Buyers.

First, your chances for an off-market deal are much higher resulting in not having to pay costly investment banker or business broker fees. Assume a Banker charges you 10% of the deal cost. In the above example of company 2, this means you’ll be required to pay a $500,000 banker fee. In the example of company 3, you will either not need a Banker, or you’ll be greater opportunity to negotiate the banker fee lower. For company three, this is a $1,100,000 fee savings.

Second, your business will be more in-demand. A turnkey house that has a new kitchen, beautiful curb appeal, and flawless inspection will command multiple offers and likely sell above ask. A business that has been preparing for exit over the past 10 years by tracking their valuation and is turnkey will command multiple “real” offers and will sell above ask. But what’s interesting is that the quality of the buyers will increase and they are more likely to have access to capital.

Lastly, when the LOI is signed, you’ll have greater leverage over a buyer who wants to reduce their offer. Why? Because you understand your business inside and out AND you’ll know that most companies in the market lack the quality of your company.

Conclusion

The earlier you know the value of your business the better. You can track your performance over time, you’ll be more prepared to bring your business to market, you’ll know the levers of why your business is valued the way it is, and you’ll have more leverage when it’s time to sell. But, the most important reason why Valuation is the most underrated metric for small to medium sized business is because you’ll exit with and be rewarded with significantly more money in your pocket. So don’t wait, have a third party value your business to see where you stand. And after you learn the results, ask for help from an Operating Partner. The small investment can result in a significantly higher valuation.