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What’s My Business Worth?

Part 2- Understanding Valuation Multiples

Photo by Magnet.me on Unsplash

If you are an entrepreneur who has thought about selling your business, you might think you already have a pretty good understanding of valuation multiples. However, in my experience across the many conversations, I’ve had with business owners, I have found that many smaller, Mom & Pop shop owners actually have a limited understanding of multiples when trying to estimate the value of their business.

Typically, a small business owner has had a conversation or two with an investor friend who told them that a business always sells for two times the revenue — which is not at all accurate. Or they may have read an online article claiming that most businesses sell for ten times the net income, which is also very inaccurate (I’ve seen these articles — they’re out there).

Calculating multiples to determine the value of a business can get a bit complex, which is why M&A professionals rely so much on organizations that aggregate and publish this data on a regular basis. Listed below are several of the multiples for businesses that I have sold in recent years.

For evaluating insurance businesses, we consider a multiple of gross commission income. For just about everyone else, we measure a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). Another term for EBITDA is “free cash flows”, or you can think of it as “net income” for now. To simplify the chart above, I used “net” for EBITDA, and “gross” for gross sales.

Factors that can affect valuation multiples include the following:

1. The size of your business — Larger businesses can control the market more easily, stand up to competition, and have more options to secure financing. Therefore, a larger business is seen as a lower risk and has a higher valuation multiple.

2. The effort required to run your business — Do you, as the owner, need to show up every day in order for cash to come in? A business that relies heavily on its seller for income tends to value at just a 1x multiple of net income, at best. When I prepare a seller to list their business, I often ask “what would happen if you take off for a week-long vacation? What about for a month? Will your business continue without you there?”

On the other hand, businesses with automated monthly recurring revenue (MRR), such as insurance, SaaS or any membership model, sell for more — between 2.5x and 5x for many, depending on the business. A company built on MRR with one-year (or longer) contracts, and a capable general manager in place, will have a high valuation multiple. Small business buyers LOVE contracts! So, yes, in fact, some small businesses will sell for a 10x multiple of net income — just not that many.

3. Your customer concentration — Diversification is the name of the game here. Simply put, if your company’s income is dependent on a few, very large customers, you will have a lower multiple. If your customer base is well-diversified, the value of your company will rise. If no single customer can account for more than 5% of your income, you’re in excellent shape.

4. The overall health of your business — Of course, your valuation can vary significantly depending on how well the business is doing. Are you growing, or have sales flattened out or even declined recently? How positive is the reputation of the company — are there Yelp reviews? Have you had any high-profile complaints or dealt with any lawsuits?

How well does your business retain customers and employees? How impactful are your business development and marketing programs? Each of these points can increase the value of your company.

5. How relocatable or absorbable is your business? — Is your business dependent on your location, like a retail shop or a company with a localized clientele? Do you have a lease that is either up soon or on a month-to-month contract? If your business is in a retail location, a solid, long-term lease will prevent buyers from perceiving your location as a risk factor.

Could your business be easily rolled up into another operation and close your current office? When the acquiring company can save on overhead expenses by pulling your operation seamlessly into theirs, your value goes up.

The moment you decide to someday sell your business — even if that someday is several years away — begin regularly reviewing the factors listed above. This best practice will help you maximize your company’s value so you can put yourself in the strongest possible position once you are ready for your exit.

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