Business Valuation Multiples – How to Choose the Right Multiple For Your Business
Using a “Multiple of Earnings” is the most popular way to value small businesses that are for sale.
But that raises a difficult question: By what number do you multiply your earnings?
Much of what has been written about valuation multiples states that most businesses are sold with a multiple that ranges from 1-5.
But in truth, smaller businesses that sell for 4 or 5 time their earnings are rare – at least when it comes to owner-managed businesses.
In smaller businesses with an owner’s benefit of $50,000 to about $250,000, the owner will usually also manage the business on a day to day basis. The buyer is in truth “buying a job”. Their return on investment is much lower because they are investing not just there money but there time.
In larger businesses, where there is enough cash flow to hire a full time, professional manager the owner can make a return on his investment without a full time commitment – so that business will be valued at a much higher level. That’s not to say you can’t sell your business for a multiple of 4 or 5, but in my experience the vast majority of smaller businesses sell for a figure much closer to 1 to 3.
So I suggest you start with a multiple of 2.0 and use the list of factors below to adjust the multiple up and down based on your specific situation and you company’s performance.
This is just a partial list to get you started, there are bound to be unique factors that affect your business that are not listed here.
Positive Factors That Can Increase the Multiple
*Sales and profits have risen consistently each year for at least 3 years.
*A significant amount of sales come from repeat customers. Even better is revenue that comes from automatically recurring charges. Web hosting, alarm monitoring and self storage are few examples of business that may have reliable repeat revenue each month.
*Proprietary products, patents and/or trademarks.
*Exclusive rights to a territory.
*Less warranty exposure than is typical in your industry.
*Management And /or employees will stay on after the sale. The more experienced or uniquely talented these people are, the better.
*The business is a franchise of a well established – And well known – company. For many buyers, the support and training they get from the franchisor is a major plus – one they are willing to pay for.
*Your industry is growing and the future appears bright.
*Important ratios such as profit margin And cost of sales are above average for you industry.
*You are offering above average financing terms
For these last two items you should check with any trade associations that serve your industry. They may be able to provide you with facts and statistics that can help you show the buyer that your business is part of a growing industry or trend.
Negative Factors That Can Decrease the Multiple
*Sales and profits have been trending down recently.
*Sale and profits have been inconsistent or unpredictable in the recent past.
*Sales from your most important product have been down or stagnant.
*One customer accounts for a large portion of your sales – more than 20%.
*There are many businesses similar to yours that are also for sale. Or your products are widely available at many places – a “Me To” product a line.
*The business relies heavily on location for its success but the lease is not transferable or is about to expire. If this applies to your business, try to get an extension on your lease before you start to sell.
*Pending legal or government issues such as law suits or environmental concerns.
*Important ratios such as profit margin and cost of sales are below average for you industry.
*A large amount of obsolete inventory.
*The business is part of a weak franchise or one with a bad reputation.
*Too many old accounts receivable that will never be collected.
*You are not offering any financing
How Do These Factors Affect the Price?
Sellers tend to focus mainly on the positive factors when talking to buyers.
Buyers, however, tend to zero in on the negatives – or what they perceive to be negative. They are averse to risk and so they will always be on the lookout for problems.
If any of the negative factors listed above exist in your business you are not alone. Almost every business has some problems and they should not stop you from successfully selling.
That these problems exist isn’t the issue, how you deal with them is.
You have several choices when it comes to the weak points of your business.
You can lower your price accordingly and show the buyer how and why you have discounted your price by lowering the multiple, you can ignore the issues and wait for the buyer to point them out, and you can fix the things that are fixable.
Or you can do a combination of all the above.
If you have old or obsolete inventory, get rid of it and take the lose. The same holds true for old accounts receivable. The buyer will not pay you any money for these things and they will only help to create a negative overall impression of the health of your business.
Other factors – such as a decline in sales in recent years or one customer accounting for much of your revenue – can’t be fixed so easily in the short term. If you don’t have the option of holding on to the business for another year or two so you can improve these things than you will have to adjust the price accordingly.
Finally, there are those items that you don’t control such as the fact that there are many similar businesses on the market or you are part of a franchise that is struggling.
I would suggest that you not lower your original asking price because of these items. But be aware that the buyer will probably bring them up at some point so be prepared to deal with them.
Before lowering your price, try first to offset any of these negatives with some of the positives features of your business. Maybe there are many businesses similar to yours on the market, but if your profits have steadily increased over the last few years or if you have a favorable lease in place that is transferable, you can show the buyer how your business is worth the price you are asking.