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Home >> Money >> Business Strategy >> Rules of Thumb for Business Valuations
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Rules of Thumb for Business Valuations

“The art of art, the glory of expression and the sunshine of the light of letters, is simplicity.” – Walt Whitman, 1890
Valuing a business is not an exact science – most people believe it to be equivalent to rocket science. Some discounted cash flow models we’ve seen look like a map of the human genome. The initial steps in business valuation should be baby steps, simple.

Let’s face it; a business is worth what somebody is prepared to pay for it – period. Don’t assume there are outlandish buyers who will pay stratospheric multiples nor should one assume there are absurd vendors willing to sell at bargain basement prices. In today’s market neither outlandish buyers nor absurd sellers exist. When establishing a valuation sensibility and clearer heads always prevail.

The art of business valuation is and should always be 3 dimensional. It has to be optically appealing to the individual across the table. First, there is the ultimate price. Second, possibly just as important as price, is how that price gets paid. The determination is how much of that price is guaranteed versus contingent on performance (i.e. Earn-outs). Third, the tax implications complete the painting (share versus asset sale) - Far too many times we’ve seen how a lower priced share purchase provides higher after tax proceeds to the vendor in comparison to a higher priced asset purchase.

Valuations for smaller middle market businesses, those with EBITDA [earnings before interest, taxes, depreciation and amortization] of between $1.0 million and $10.0 million, have historically fallen between 3 to 6 times multiples of EBITDA – often referred to as the ‘goal posts’ of lower middle market valuations. Now this is not to say that multiples have not fallen outside of this range, they certainly have, but they are more commonly outliers than the norm. Businesses that are haemorrhaging require a whole other discussion.
 
Let’s look at a hypothetical example of a business with EBITDA of $2.0 million. We would multiply by the EBITDA by 3 to get a valuation at the lower end of the scale or one side of the goal post to arrive at a valuation of $6.0 million. Conversely, we would multiply the same EBITDA by 6 to get the high end of the valuation range or the other end of the goal post of $12.0 million. Although, there is a large gap between the two relative numbers, it provides parameters to work within. There are five (5) business fundamentals that push the scale in one direction toward those parameters.

Here are the fundamentals:

 
1. Barriers to entry - if the business hasn’t built a ‘Chinese wall’ to protect its competitive position chances are someone is going to waltz in and steal the business. Typically, the higher the barrier is the better the multiple.
 
2. Size and growth - Smaller firms tend to not have systems in place that are scalable, usually the owner operator has his or her hand in every facet of operations – They’re usually the business. Also, if revenues and profits have flat-lined over a number of years, the valuation tends to fall on the weaker end of the goal post.
 
3. Management - Good people are hard to find. If the business is coming with a solid management team that knows how to run with the business, especially with a new mandate, complimentary services and additional resources that come with an acquisition, chances are the buyer is going to be just as excited - And pony up.
 
4. Peer group comparables - Gross margins and profits higher than the industry average is like having a sack of potatoes dropped on the valuation scale. It means the business is firing on all cylinders. Peer group comparables are easy to find via public company information.
 
5. Customer concentration and stickiness - if one customer is providing an exceptionally large contribution of revenues and profits, especially in excess of 15%-20% of revenues some red flags might go up. The higher the customer concentration the quicker that same sack of potatoes will convert to a sack of feathers. Customer stickiness refers to how difficult it is for a customer to move from one provider to the next, commonly referred to as ‘switching costs’. The higher those costs are for a customer to switch providers; the ‘stickier’ they become and subsequently the better the multiple.
 
These fundamentals reviewed and analyzed together should give you a guide – much like a compass. There will always be gaps between seller and buyer on perceived business value. The savvy negotiators will know how to bridge those gaps by effectively leveraging the three dimensions, and bringing ‘simplicity’ to an often complex discussion.


Published 5th Mar 2010

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