When determining the value of a business, buyers will often apply a “multiple” to some proxy for the company’s cash flow, such as EBITDA (earnings before interest, taxes, depreciation and amortization). While our previous article focused on how a seller can unlock value through identifying “add backs” to increase cash flow, we now turn our attention to maximizing the other variable in this equation – the multiple.
Transaction multiples can be defined simply as a reflection of two things: risk and growth. Relative to risk, the growth factor can be more easily quantified (revenues or earnings today vs. projected). Risk, on the other hand, is more difficult to measure – and is typically defined using a baseline from similar private and public markets. From this baseline, potential buyers will adjust for other factors they perceive as higher or lower risk; thus increasing or decreasing value. Certain factors buyers consider when adjusting multiples are listed below:
Put simply, larger companies typically garner higher multiples. Investors generally accept that, all else held equal, larger companies within the same industry have greater access to capital, more diversified customer bases, and reduced vulnerability to one-time events and market fluctuations, among other factors, when compared to their smaller counterparts. Companies with a potential exit on the horizon can look to increase size through growth in services and markets, as well as acquisitions. These things do not happen overnight – so time may not be on your side.
Companies experiencing recent or sustained growth in terms of revenues and/or EBITDA are more attractive to buyers. Buyers want to generate a return on their investment, and will typically pay a premium for a “running start.” Companies should maintain budgets, projections, and backlog to help manage future growth.
Placing a value on a business is inherently a forward-looking process. However, past performance is often a buyer’s preferred tool for assessing future potential. Companies with a history of stable margins can give buyers more confidence in projections. Moreover, if and when there is a “blip” in margins, companies that can isolate and demonstrate that it is non-recurring may be able to remedy perceived risk from buyers. These blips in margins are frequently attributable to securing new customers, entering new markets, or non-recurring process/input cost incidents.
Diversification can be represented through several different factors, such as customers, suppliers, products and services, and operating regions. Reducing concentrations in each of these factors can help mitigate the risk associated with losing a key customer or supplier, experiencing curtailed demand for a particular product or service, or succumbing to regional economic fluctuations. Companies with good internal accounting and marketing data on segment information such as customers, products, and regions can better illustrate their diversification to potential buyers.
On its face, this may seem to run counter to the prior strategy on diversification. However, proprietary products or services offer buyers an investment that may provide competitive advantages that are difficult to replicate. This does not necessarily have to be a stand-alone patented technology or product (although that helps) –it could be a refined set of processes that a buyer may be willing to pay a premium to acquire.
In general, good people and teams (that can be transferred) will increase value. Unless your business is completely automated and technology-dependent, chances are your management depth will play a critical role in how potential buyers perceive the risk in determining value for your business. This is one of the biggest factors that can influence value – and one of the hardest to develop, retain, and transfer to a potential buyer. A brand, product, or company is often only as good as the people who created it.
People are creatures of habit, and we like to know what to expect (at least when it comes to investing our money). Accordingly, businesses that can demonstrate recurring and predictable revenue can drive higher multiples for their business. You might think this is counterintuitive to diversification, and the answer is “yes (sort of).” Recurring revenue is good, and recurring revenue from a more diverse set of customers and/or products is better. Companies that can demonstrate repeatable revenue streams via contracts, history, or other facets can help alleviate risk in future projections.
As shown above, business owners have several factors within their control to influence transaction multiples and drive values higher. P&N provides transaction advisory and consulting services to help you navigate and understand the elements involved in driving value for your business. Contact us to discuss how you can identify and leverage opportunities to improve your position as a seller.