Levers that Impact EBITDA Multiples for Business Valuation
There are multiple levers that impact a firm’s business valuation. The complete list is likely as exhaustive as any buyer due diligence checklist. Understanding how various levers impact a firm’s EBITDA (earnings before interest, taxes, depreciation and amortization) multiple and ultimate valuation can play an important role not only in the exit itself, but in the planning process that precedes it. Just as valuation multiples and “rules of thumb” vary from company to company and industry to industry, so too do the levers that drive them. However, there are high-level valuation and profit-multiple metrics which are essentially agnostic across industries. Here are just few.
Size of EBITDA
There are typically valuation step-ups as a company’s earnings increase. These EBITDA size thresholds tend to occur at very predictable levels, typically occurring at $1,000,000, $2,000,000, $3,000,000, $5,000,000 and $10,000,000. At each threshold the complexity of the business, including the complexity of the accounting, finance and operations needs to move in lockstep with the increase in earnings. In addition, the type(s) of private equity groups interested in a business shift with each step-wise increase in earnings. Private equity groups speak in terms of “EBITDA minimums” and “minimum check sizes”–which are convoluted ways of saying essentially the same thing.
Customer Concentration
Diversification of revenue is a major driving force behind business value. It is a question I almost always ask in my preliminary due diligence and client-vetting meetings. Ideally, no one customer holds >10% of gross annual revenues. Most earlier-stage companies typically include a flagship customer they point to, but many fail to immediately diversify beyond their initial penetration and market test. The companies that get investors salivating are those who hold a truly diversified customer base. Diversifying revenue is typically much easier in B2C business models. B2B can be much more solid for revenues, but much more difficult for diversification.
Truly diversifying is a matter of sales, marketing and business planning. It means a product or service that is actually demanded in the marketplace. Unfortunately for most business owners, customer diversification is like oil in an engine. It does not necessarily increase the value of the vehicle, but if the business has been running without it, the value is significantly reduced.
Macro Trends
General trends in the macro-market likely have one of the biggest single impacts on business value. Many firms looking to sell in 2009 and 2010 were compelled to take themselves off the market. Valuations had hit the doldrums in a major way. It is an unfortunate truth that business owners hold little to no control over what happens in the general market. And, since no one has that proverbial crystal ball, the timing decision of when to sell is very much tied to the general market.
In addition to the general macro trends for the general market, there are industry-specific trends, multiples, discounts and premiums inherent to the nuances of a given industry or market niche. For instance, some industries include rules of thumb with companies trading on some multiple of revenue while other firms trade on gross profit or EBITDA.
Growth Trajectory
High-growth firms that can show a trend that does not appear to have the potential of abating anytime in the near future will almost always receive a higher multiple for valuation–all things being equal. The assumption is that if growth continues to march forward at a similar pace, the buyer will be able to capture the excess value. The tip to business owners is simply this: build momentum for an upswing in revenue and profitability and then sell into it.
Process
An investment banker will tout his/her process all day long. A typical M&A process is somewhat industry agnostic. A quality process involves bringing the perfect mix of the right buyers (always plural) to the table at the same time. With the right buyers in-tow, a business owner is likely to obtain the highest premium with the right amount of demand for his/her business. The right marketing list combined with the right marketing process and negotiation is perhaps the best way to bolster value for garnering a premium.
I have always felt it a cop-out answer to say, “it depends” when speaking of valuation, but it always does. In the regular conversations I have with business owners, I am always asked, “what do you think my business is worth?” Because I am almost always asked this in an initial conversation with only knowing cursory data on the company’s performance, I invariably reply with something like, “I do not know enough to make that determination.” In times past, I might take a stab at it. In the seller’s mind, I was always wrong. “My business is worth much more than that to the right buyer.” Perhaps it is, but investment bankers are running blind without all the facts. For instance, is the net profit number an owner just rambled off over the phone truly accurate. It could be high, but it could also be very low. If they are sheltering expenses for taxes, it is likely low. What about factors like debt ratios, strategic Intellectual Property and growth trajectory? Without a recent transaction in the direct industry under the belt an investment banker is likely to go off of gut, but valuations are very different for healthcare technology firms vs. a manufacturing business.
Again, what has been outlined here represents a very small sample size for all the potential drivers of business value. What is your business worth? Would you like a free business valuation? Get in touch with our team for a free valuation today to find out what your business is truly worth.
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