Most of the time, privately held businesses are valued as a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization.) EBITDA is used rather than net income because it more closely reflects the cash flow generated by a business, irrespective of its capital structure. Occasionally a company will be valued as a multiple of revenue, but this is usually reserved for very high growth technology companies.
The difficult part for sellers is understanding what drives the multiple. Middle market deals generally fall into a range of multiples from 3-4x on the low side to 8-10x on the high side. So why does one business sell for 4x while another goes for 8x? Here are some of the factors which drive multiples:
- Supply and Demand
Companies in attractive, high demand industries will command a higher multiple than those in more basic or out-of-favor sectors. Today, healthcare and high tech are two examples of high demand sectors which are generating very attractive multiples. The supply side also matters. If there are plenty of well managed, profitable companies on the market (i.e. oversupply), prices will generally be lower. On the flip side, if there are lots of buyers chasing too few deals, multiples will go up. - Growth
Despite the focus on the last 12 months of earnings, purchasers are buying the future. What matters to a buyer is not what your company earned last year, it’s what your company can earn in the future. Thus, businesses with high potential growth rates will sell for higher multiples than slower growth companies. - Risk
Risk plays a role in every financial decision. We all know that safer assets like U.S. Treasuries (just go along with me here, please!) have lower rates of return than high risk investments, like junk bonds. The more risk a buyer is willing to accept, the higher the return he will demand. Said another way, a buyer is going to offer less for a company he perceives as having a lot of risk.
Risk can come in many forms. It may be related to a customer concentration issue, or something like technology risk. Perhaps there is the risk of product obsolescence or the threat of new competitors. - Volatility
Volatility is closely related to risk. If a company’s earnings are highly variable (such as companies related to commodities like oil and gas production or metals) the valuation may be lower because of the unpredictable nature of earnings. This is why buyers love companies with recurring revenue streams and long-term contracts with customers, they represent predictable earnings. - Strategic Value and Synergies
A strategic buyer will often pay more for a business if they believe the combination has many synergies as well as the opportunity for cost reductions. These buyers may also bid up a deal if they wish to keep the target company from being acquired by a competitor. - Intellectual Property
Businesses with intellectual property (patents, trademarks, licenses, etc.) can be worth more to a buyer than a similar company without intellectual property. Buyers will also pay more for companies with proprietary products and processes.
While any or all of these factors can impact the value of a particular business, it is important to keep in mind that there are also intangible factors that impact value, such as cultural fit. Every situation is unique. That’s why it is so important to work with an investment banker who will take the time to understand what makes your company valuable to buyers in order to get the highest possible price.