The approach to value they are using is a basic rule-of-thumb derived from a market comparable approach, where value is based on comparing data such as sales price, revenue, and cash flow from other similar businesses that have sold. For example, if the average business in industry XYZ had a sale price of $1 million, revenue of $1 million, and $500,000 in seller cash flow, than the industry would be said to have businesses that sell for 1 times revenue, and 2 times seller cash flow. If your business had $400,000 in revenue and $150,000 in seller cash flow than it would be estimated to be valued at approximately $300,000 to $400,000, with some people averaging it to be $350,000.
Many people are familiar with this approach since a similar methodology is commonly used for more homogeneous assets like real estate. Unfortunately, this approach doesn’t work as well for unique assets and businesses that have greater variability and moving parts.
Following are 10 questions to ask if using a rule of thumb or a market comparable approach for valuing a business, that may make these approaches problematic:
- Is the business really an average business that has very similar characteristics to the businesses that have sold?
- How much data was collected to establish the multipliers, and is it complete enough and representative enough of businesses similar to the business being valued to make a valid comparison?
- Is the business model of the company being valued truly similar to the sold comparable businesses?
- Are the rates of growth similar? If Company A and Company B both have $500,000 in Seller Cash Flow and a market comparable multiplier of 2x Seller Cash Flow is utilized it would indicate a value of $1 million for both businesses. However, if Company A had average historic and projected annual growth of 5%, while Company B had average historic and projected annual growth of 15%, and you paid $1 million for each business, then two years later Company A would likely have $551,250 in seller cash flow, while Company B would likely have $661,250. Yet, the industry comparable businesses may have had an average annual growth rate of 10%, so the average business in the industry would likely have $605,000 for the same time period. Different growth rates warrant different prices.
- Are there different risk factors? An example of this would be if Company A had one client that provided 40% of its revenue, whereas the average business in the industry had diverse clients with the largest average client providing only 5% of a typical comparable business’ revenue. If Company A lost their top client it would be devastating to the business. This level of comparative risk should result in a price that reflects that risk.
- Did the comparable businesses sell during the same part of the economic cycle?
- Are the sold businesses of a similar size? This is a particularly important question when looking at very small companies. If, for example, the average comparable business had seller cash flow of $120,000 and the business being valued has $500,000 in seller cash flow than the business being valued should command a higher multiple. The reason is that if you were to hire someone to run the business you may be able to do so for around $120,000. For the business that only had $120,000 in seller cash flow that would leave it with $0 in EBITDA remaining after paying the seller's salary. For the business that had $500,000 of seller cash flow If you had to pay replacement CEO $120,000, it would be left with $380,000 of EBITDA. Buyers will pay more for a business that provides a real return on investment after paying for management labor.
- Does the business have initiatives underway that will likely lead to future increases in revenue and/or cash flow? A market comparable approach is a backward, rather than a forward looking approach to value, so it will not take into consideration strong unproven increased future earnings potential.
- Does the business have un-utilized or under-utilized assets? For example, if a business acquired a $200,000 piece of equipment but then decided not to utilize it but had it sitting in the warehouse, a market comparable approach to value will not recognize the additional value of that non-income producing asset.
- Were sold comparable business’ financials reported accurately? When a business is sold, usually the financial statements have been re-cast to reflect adjustments for non-recurring or personal expenses. However, those aren’t always accurate adjustments. For example, a business owner may have failed to accurately adjust the financials to reflect the under-payment or over-payment of compensation to him- or herself. A business owner who only pays himself a $40,000 annual salary, when a market rate of compensation for his position would be $100,000 and who fails to make this adjustment on the financials would show EBITDA that is $60,000 more than it should have been if an owner were being paid a market salary. If an EBITDA multiplier were utilized this may produce an inaccurate estimate of value.
These are just some of the types of issues that make the use of a simplistic market comparable multiplier, or a rule-of-thumb derived from such an approach, trickier than many people initially perceive. A knowledgeable business appraiser, business broker or investment banker can help you explore other approaches to value and examine issues that may impact valuation and marketability.