Valuation Metrics for Small Businesses
Selling a business can be a hard decision for entrepreneurs, both emotionally and financially. The sad reality is that when it comes to gauging your company’s true intrinsic value, your startup costs and incurred losses mean nothing when faced with cold, hard valuation metrics. As a small business owner, you should be familiar these valuation metrics to understand how prospective buyers calculate your business’ worth. EBITDA EBITDA (earnings before interest, tax, depreciation and amortization) is the most commonly used valuation metric for businesses. These are simply your raw profits before all the messy accounting deductions muddle up your company’s true bottom line. EBITDA is considered the “gold standard” of private mergers and acquisitions. If your company is in a hot growth industry, you should expect a significant acquisition premium – a buyout offer that is several times your most recent EBITDA. Private equity firms have been known to pay multiples up to 6-8 X EBITDA. However, even at these high valuations, you might think that the buyer’s offer doesn’t account for your past expenditures and the future growth potential of your product. In fact, many tech firms end up sacrificing their EBITDA to pursue future growth – a strategy often used by Google, Microsoft and Amazon – which can negatively impact buyout offers based on EBITDA. Many deals fall apart for this reason – buyers claim that the sellers are being too greedy, while sellers claim that buyers fail to see the long-term potential of its expenditures or acquisitions. This is referred to as the “classic valuation gap”. Mind the Gap Just because you and your prospective buyer have reached an impasse at the valuation gap, that doesn’t necessarily mean that the deal is off the table. Unless you possess a valuable technology that can be leveraged for future growth, you’ll have a hard time convincing the buyer otherwise. You’ll likely have to meet the buyer somewhere in the middle through intense negotiations, and prove that your company’s ROI (return on investment) and growth potential can justify a bigger EBITDA multiple. You’ll need to get a business broker, M&A advisor or investment banker in your corner to help you find a transaction value and structure that is acceptable for both parties. Traditional buyers don’t like to see a business too highly exposed to a single, cyclical product. Commodity type products are highly exposed to these fluctuations. For example, an iron ore miner will make substantially less if the spot price of iron ore falls from $160 to $40 over a single year. The business won’t have any control over the price, which is defined by the market, and will have to ride out the macroeconomic storm as best as it can. As a seller, you could try to convince the buyer that the macro environment will change in the coming year, but it is a hard sell, but might be accepted by industry peers looking to consolidate horizontally across the sector. The “Earn Out” For two parties at a valuation impasse, an “earn out” is a possible solution. An earn out is an additional transaction value based on the seller’s annual sales revenue over a five year period. An example agreement is to sell the company initially at a 4X EBITDA multiple, but add an earn out provision that allows current shareholders to earn 6X EBITDA based on revenues at the end of the five year period. This can be a risk to the seller, especially if the company fails to hit its projected targets over that period, but is mutually beneficial for both parties. This transaction structure strikes a good balance for companies that have a weak EBITDA but a projected revenue growth of 50% or more over the next few years. This also gives the buyer an added incentive to accelerate the company’s growth and boost the acquired company’s margins to reach the promised targets. Court Multiple Buyers Buyers will usually attempt to buy out your business at a steep discount through a manipulation and distortion of these valuation metrics. Court multiple buyers to cause a pricing war, and play along to get the best deal for your small business.