The nice payoff for building your business is the reward you get when you sell it. Unfortunately, some entrepreneurs miss out on a big part of this reward.
Why?
The Problem
Some entrepreneurs don’t understand the real factors that go into valuing a business, and they don’t keep the adequate financial records that will allow them to get that value.
That said, they still have seriously inflated beliefs about what their businesses are worth.
Though most industries have a rule of thumb for doing valuations that are expressed as a multiple of sales, it’s only done as a matter of convenience. That’s because you can’t truly value a company just by looking at its sales.
The Reality
The truth is that buyers are more interested in free cash flow. And free cash flow is a function of profits, not sales.
To get a better idea of what your business is worth, you need to understand what potential buyers are looking for. For example, they may want to buy due to
- Strategic reasons
- To gain market share
- The potential for synergy
- To boost their bottom line
An Important Number
But whatever’s driving them, it’s highly likely that the first number they’ll look at is your earnings before interest, taxes, depreciation, and amortization (EBITDA). And when you subtract from that number the minimum amount of new capital expenditures needed each year (CAPEX), you get a good measure of free cash flow.
In other words, this is the cash you generate each year after paying operating costs and meeting new-capital requirements, but before paying taxes and interest and before deducting depreciation and amortization.
Yet even if your company has solid EBITDA and you can prove it, there’s still more questions you have to answer. For instance, buyers may these questions.
- Where does your EBITDA come from?
- Do you have a broad base of customers?
- Have they signed long-term contracts with you?
- Are your prices in line with the market?
If you have a few big customers that contribute over half of your sales, the loss of those customers could devastate your business. Smart buyers will make a note of this danger, and discount your business accordingly.
Or worse yet, they may decide it’s not worth buying at all.
The Real Value of Your Business
But if you can answer the questions above to your potential buyer’s satisfaction, you can expect to receive between five and ten times EBITDA for your business.
The exact multiple will depend on a few factors, such as interest rates. If they rise, and money gets more expensive, the multiple will likely fall. If rates decrease, the multiple usually rises.
The multiple can also be affected by the amount of competition among potential buyers, or the number of good businesses available. But in the end, your business will be worth between five and ten times EBITDA.
Why?
Because what purchasers buy is the potential to make money in the future.
The more money they’re likely to make, the more they’ll pay. But if there’s a greater chance that the cash flow will be cut off, they’ll be willing to pay less.
To learn more about valuing a business, check out The Knack by Norm Brodsky and Bo Burlingham.
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