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How to Value a Business

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Valuing a business is complex.  Experienced practitioners have written novels on the subject, but we don’t have time for that here.  Instead, this represents a high level crash course in business valuation using the “EBITDA multiple” method, which is the most common valuation methodology used by private equity firms, strategic buyers, etc.

Q: How are businesses similar to homes and baseball cards?

A: They are all worth what the highest bidder is willing to pay for them, no more – no less, regardless of what any book says.  As a result, businesses are typically valued based on sale prices of comparable companies (“comps”).  Just as homes in your neighborhood of similar size represent a “comp” for your home, a business comp is roughly defined as another company in your industry, of similar size and similar cash flows.

Valuation Step 1: Calculate EBITDA:  The most basic reason companies have value is because they generate cash; they are an investment that returns cash.  The starting block of every company valuation is calculating its cash flow, or “EBITDA”.   EBITDA is a quick & dirty estimate of the company’s free cash flow; the pool of cash generated by the company’s normal operations, available to make investments and service debt after all other operating expenses have been paid.

Valuation Step 2: Calculate the EBITDA Multiple: Once you calculate the EBITDA, it should be multiplied by a factor, generally between 4x-6x (the “EBITDA Multiple”) for small businesses.  For example if you have a high growth company that spews $100k of cash like clockwork each year, you might be able to sell your business for $600k ($100k EBITDA * 6.0 EBITDA Multiple).  Conversely, if your EBITDA bounced unpredictably between $10k and $150k over the last 10 years, your company is probably worth much less than $600k because a buyer cannot accurately predict how much cash your business will generate going forward.  Here are some key factors that influence your EBITDA Multiple:

Comps:  The starting point for your EBITDA Multiple is likely to be whatever Multiple was used in the last few competitors that were sold in your industry.  This can be difficult to find for smaller businesses, which have much less data available to the public.

EBITDA Predictability: The more predictable your EBITDA, the better “valuation” you will receive.  For example, if your customers are obligated to pay you $X every month (a “subscription model”), than you will receive a valuation boost; there is comfort that the company will continue to generate cash in a predictable way.  If you have “lumpy” sales that rely on winning new, large one-time contracts each year than your valuation will be discounted significantly relative to those that generate more predictable cash flows.

Growth & Market Share: If your EBITDA has been growing each year at significant (e.g. 10%+) rates and are expected to continue to do so, you will receive a higher multiple (e.g. 6x-7x).  If you also have a huge piece of a growing market (e.g. Apple) you may receive an even higher multiple.

As a practical matter, the ability to find debt to finance a portion of the buyout can also impact valuation.  Analogy: if one home is ineligible for mortgage financing, it won’t be as in demand as one that’s debt eligible.

The takeaway here is that each $1 of expense costs you $4-$6 of valuation, so spend wisely.  Focus on EBITDA.  And the more predictable and sustainable your cash flow, the better!

For those looking for a more detailed valuation crash course, I recommend reading “Valuation” by Copeland, Loller, and Murrin at McKinsey & Co.  Disclaimer: nobody knows how to value a startup.

For further information, contact Brandon Hinkle at bhinkle@plurafinancial.com. Brandon is the Co-Founder and CEO of www.plurafinancial.com, a free online matchmaker between banks and small businesses seeking debt financing.

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Written by entrabanker

February 9, 2012 at 10:48 pm

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