Written by Mark Richardson for The Business Transfer Advisor.
Almost every business owner I meet who is considering selling their company asks me about using pricing multiples. Before I answer their question, I ask them to think about two very different manufacturing companies in the same industry. Each business has annual sales of $12,000,000 with a net income of $700,000.
Company A has been in existence for over 20 years. While gross margins are adequate, Company A prices each new manufacturing job on a bid-basis, and negotiated jobs are based on the owner's personal relationships with the customer. Product quality is good, but Company A's equipment is aging, and there is a significant amount of deferred maintenance. The firm is highly leveraged, and working capital constraints limit the amount of new work the company can take on. Sales have remained at the current levels for the last three years.
Company B develops and manufactures products, and sells them through diverse distribution channels. Customers contract for future delivery, and Company B uses a sophisticated inventory management program to plan production and control costs. Research and development programs have resulted in new products and top line revenue growth of 15% annually over the last three years. Company B's management team runs the daily affairs of the business, and the owner works on the company's future. The owner arranged an outside board of directors and advisors that hold regular meetings. The company's accounting firm prepares reviewed financial statements annually.
Which company is worth more?
Using a common industry multiple may result in overvaluing Company A and undervaluing Company B. Business valuation multiples simply represent a summary of trends based on a broad range of completed business sales. The multiples are industry specific, offer a wide range of estimated value, and do not consider the payment structure. As a result, multiples are generally used for smaller businesses.
As an alternative to using multiples, business owners should look at the company's value from three perspectives: economic, market and strategic.
The economic value of a company is what it is worth to the owner or, the monetary value required to replace the owner's current income stream and economic benefit.
Market value is what a new owner or investor is willing to pay for the company. Business owners should compare the company's market value to its economic value prior to going to market to determine:
If a potential sale is viable
If a sale will meet the owner's personal and financial objectives
If an offer results, would it be something the owner would accept.
Strategic value is what a company could be worth. Businesses are purchased because buyers identify value drivers in the target company that can either improve or enhance the acquirer's existing business. Sellers who identify buyers' strategic objectives -- and position their companies to meet those needs -- negotiate better and receive higher sale prices.
Brokers, intermediaries and investment bankers may contribute information to transactional databases used to determine multiples, yet sellers should realize that specific deal values on private company sales are difficult to obtain and may be obscure. The real value in the transactional database research is that it identifies buyers -- which investors or companies are buying in the market today.
Finally, a comprehensive market evaluation is a valuable tool for business owners. During the evaluation process, the owner develops a deep understanding of the business itself, the client base, the assets, employees, industry focus, competitors, and intangible resources – from the viewpoint of a business marketer. Recasting the financial statements organizes the owner's current economic benefits. Most importantly, the evaluation identifies the high value drivers and low value diminishers, the most significant benefit of the analysis, because these factors help the business owner make the company more attractive to the market.
Sellers who reconcile the economic, market and strategic values of the business will gain a thorough understanding of the company and make better decisions than owners who rely on multiples and "rules of thumb."