One of the best things an owner can do to maximize the value of his or her business is to take a step back. Work ON the business as opposed to IN the business.
Owners who work IN the business are often surprised and disappointed that their business is not worth what they expected. Buyers will want to mitigate the risk of buying such a business by paying either a lower multiple (price) or having the owner keep some skin in the deal through vendor financing or holding some equity and getting part of the proceeds paid out over time.
In his 2015 article ‘Demystifying the Multiple’ Craig Maloney explains the most common misconceptions about value.
When it comes to succession planning for business owners, the two most common questions asked are: “What is my business worth?” and “What is the multiple for my business?” Seemingly simple questions; however in order to get at the answers, one must first define what is meant by “worth” and, secondly, what the “multiple” is being applied to. Some of the most common mistakes made by business owners when quantifying what they think their business is worth involves the application (or misapplication) of the multiple. Another common mistake is underestimating the role of the qualitative factors that go into the selection of an appropriate multiple—the same factors that make a business more or less valuable and sellable.
WHAT IS IT WORTH?
When business owners ask what their business is worth, they are typically referring to the price they can expect if they sold the business.
Broadly speaking, price is measured by a specific buyer’s assessment of the company’s risk and return, which is guided by the concept of ‘fair market value’. Fair market value is defined as “the highest price, expressed in terms of money or money’s worth, available in an open and unrestricted market between informed and prudent parties acting at arm’s length and under no compulsion to transact.”
MULTIPLE OF WHAT?
A business is commonly valued by referencing “a multiple” which is a valuation metric that is determined after considering the market’s perceptions of the risk and expected future growth return inherent in the target business and its industry.
The multiple can refer to various metrics (such as a multiple of revenue, EBITDA, after-tax earnings, or cash flows). The appropriate metric is typically a key performance indicator for the target company. Most business owners think in terms of a ‘multiple of earnings’, for example, “I should be able to sell my business for 5 times earnings.”
THREE COMMON MISTAKES
Three common mistakes when business owners try to quantify the value of their business include:
Not using the industry rules of thumb correctly;
Applying the right multiple to the wrong metric; and
Overlooking the balance sheet.
It’s important to use rules of thumb with caution. One size does not fit all. There are rules of thumb that have come to be used in some industries that are based on industry-specific metrics. For example:
Internet or social media based companies may use a multiple of clicks, conversions, or users/ unique visitors;
Hotels or homecare facilities often use a multiple of the number of rooms or beds; or
Insurance agencies will refer to a multiple of annual commission revenue.
OTHER FACTORS IN DETERMINING THE MULTIPLE
There are other factors that come into determining the multiple of your business including:
Enterprise Value Vs. Share (Equity) Value
Qualitative Factors
To learn more about how to determine your business multiple read the entire article here