What’s inside the black box of earnings & multiples
Most business owners understand that small to medium sized businesses are commonly valued by potential purchasers based on some multiple of earnings. Seems pretty simple, right??
Just multiply one number by another number and BINGO – you’ve got your selling price. Now all that’s left is to deposit the cheque in your Cayman Islands bank account and order your first BananaMama!!
If only it were that simple. The “earnings” number can take time to figure out, but with the help of a smart accountant (or better yet, an even smarter Certified Exit Planning Advisor), it is do-able. The challenge is that there are many definitions of “earnings”, and selecting the one most relevant to your business takes expertise. In most cases, EBITDA (Earnings before interest, taxes, depreciation and amortization) is the “earnings” of choice, and after a few adjustments to normalize things and remove “non arms length” influences on earnings, you should be able to determine that component of the valuation calculation.
But then comes the really hard part. Determining the correct multiple of earnings is about 90% art and 85% science (okay, nobody said accountants were good at math!). The range of multiples can be pretty wide, from 1 times earnings for risky businesses to 5 or 6 times earnings for strong, steady growth businesses. But typically, the majority of businesses with values in the $1 million to $10 million range sell for 3 to 5 times earnings. So far, so good, right?
But that is a huge range when it comes to the size of your cheque. If your business has “earnings” of $600K, a value of 3 times earnings is $1.8 million, but a value of 5 times earnings is $3 million. That is a 67% higher valuation – a big enough difference for most business owners to ask a very important question: How is the multiple determined and what can I do to increase it? (Well, that is technically two questions, but I only used one question mark, so I think I am okay).
Here is a simple explanation to a very complex issue: The earnings multiple is higher or lower, based on the purchaser’s perception of the risk that the earnings will or will not be maintained for the several years after the purchase.
If the purchaser is concerned that the historic level of earnings will not be maintained after the purchase, the multiplier will fall to the low end of the range. If the purchaser is confident that earnings will be maintained (and could potentially grow) after the purchase, the multiplier will increase to the high end of the range.
That is where the “value enhancement” component of business exit planning comes in. The Exit Planning Institute has identified 56 factors (called “value drivers”), each influencing the risk that earnings will, or will not, be maintained in the future. For example, customer concentration is a value driver – a high concentration of sales to a few customers creates risk that earnings could fall if those customers are not retained after a purchase. The involvement of the business owner in day-to-day operations is another value driver – a high involvement creates the risk that the business might struggle after the owner is no longer the owner.
The value enhancement process identifies which value drivers are in a negative position, increasing the risk that earnings might not be maintained in the future, and identifies strategies to mitigate or overcome the risk. By reducing the negative value drivers, and increasing the positive value drivers, potential purchasers will be more confident that earnings will be maintained (or will even grow) after their purchase, and will be prepared to value the business at higher multiples of earnings.
The value enhancement process can take time, which is why most Certified Exit Planning Advisors recommend starting 3-5 years prior to a potential sale. Not only does that provide time to go through the process, it allows for the changes identified to be implemented and become the “new normal” in the business.