The Myth of Five

Common Rule of Thumb

I often hear from people in passing conversation that businesses should be valued at five times EBITDA. This is a rule of thumb which certainly makes valuation easier but is it based in reality? The truth is that many factors go into what multiples a company can fetch, the main ones being:

·???????The industry in which the business competes;

·???????The type of business (manufacturing, distribution, retail, services);

·???????The quality of the underlying business;

·???????The future prospects for the business in question;

·???????External factors such as inflation, interest rates, and the economy in general; and

·???????The size of the business (especially the size of the sustainable cash flows that can be generated).

Let’s explore each of these in more detail below.

Industry

There are various factors in the industry which can impact how a business is valued. Key questions that will be explored by a prospective buyer are:

·???????Is the industry in growth mode, mature or in decline?

·???????How many competitors exist currently?

·???????Are customers price sensitive?

·???????Do suppliers have strong pricing power?

·???????Are there significant barriers to entry or is it easy to start up and compete tomorrow.

In general, the more competitive the industry is, the harder it will be to make above average margins. This will play a large role in what type of multiple your business might receive. Conversely, companies with competitive advantages over industry peers may be able to fetch both above average margins and valuation multiples.

Business Models

The type of business you are in will play a large role in what multiple you will get. For example, in general, manufacturers usually receive higher multiples than service-based businesses. This may be due to manufacturers owning tangible assets that can be liquidated, plus being naturally more transferable than many service-based business where the value may be personally attributable to the owner. However, applying a broad brush to businesses using rules-of-thumb and generalizations can lead to incorrect valuations. Instead, when attempting to ascertain a reasonable multiple for a business, we need to ask questions such as:

·???????Is the business asset intensive, labour intensive, or primarily driven by intellectual property?

·???????For asset intensive businesses, have the current owners kept up on capital expenditures?

·???????If the company is a manufacturer, do they own the intellectual property for the products they manufacturer or does someone else? Are they operating at capacity or is there slack in scheduling? To what degree is there spoilage?

·???????For distributors, are they value-added wholesalers or simple manufacturer? Are they exclusive distributors for a products or one of many? Is their product base concentrated or very broad (thousands of different products)?

·???????For retailers, do they sell their own branded goods or branded goods from outsiders? Do they use a franchise model or company owned stores? Where are their stores located? Malls? High-traffic areas?

·???????For service providers, the key question is personal versus commercial goodwill. Can the owner separate themselves form their own business or is the book of business intrinsically tied into the owner? Are services low-volume, high ticket in nature or high volume, likely competing on price? What are barriers to entry for competitors?

When valuing a business, we can’t assume a company is simply average. We have to assess both the quality of the company itself, along with the quality of its earnings relative to its peers and ask ourselves the question: is this an above or below average business? Is it best-in-class or potentially untransferable? We have to make this assessment in blunt, realistic manner.

Quality of Underlying Business

In the Middle Market, no one factor influences the sales multiple more than the quality characteristics of the underlying business. Business valuators refer to this as “company specific risk”, but really, what we are simply focused on here is the overall quality of a business in how it runs on a day-to-day basis.?A company can be financially strong but still have a high company specific risk. For example, lifestyle businesses are notoriously lucrative but many are untransferable because once the owner steps away from the business for any length of time, the business crumbles.

When assessing a business, here are some questions worth asking:

·???????Does the business have a competitive advantage over its rivals?

·???????Does the company have a written business plan?

·???????Does the company have a management team who can allow the owner to step back and take a more strategic role?

·???????Are the company’s key systems and processes documented for all major functions, thus allowing new employees or new owners to pick up where the legacy team left off?

·???????Does the company have a core purpose and long-term vision? Do they have a system in place to realize its core purpose and vision?

·???????Does the company generate margins that exceed its peers?

·???????Does the company have a history of consistently earnings healthy profits?

After our investigation, we should have a sense of whether this company is below average, above average or best-in-class. Or perhaps it is very strong in some areas but weak in others. Those weakness, however, will be discounted by prospective investors.

Future Prospects

All other things being equal, the better the future prospects for a company, the higher the potential multiple. However, there is a big caveat here. Having potential in itself doesn’t make something valuable. What does make a business valuable is: proof of concept to support such growth, a solid business plan explaining how growth will be achieved, in addition to a detailed financial forecast which outlines the economic of this future growth.

External Factors

External factors such as inflation, interest rates, and the overall general economy play a role in the multiples companies can fetch when its time to be sold. Inflation impacts some business worse than others. A company prone to higher inflation may sell at relatively lower multiples compared to other more inflation-proof companies. Interest rates impact the cost of debt and can also slow down the economy as a whole. If interest rates are trending upwards and this trend seems to be more long-term in nature (versus one-off events), then multiples may fall since interest rates impact valuations. Lastly, if the economy is heading into or in the middle of a recession, multiples will likely trend lower as the number of buyers move to the sidelines and bankers will be tighter with lending.

Size Matters

I’ve said this before, but size does matter when it comes to valuation and multiples. For example, size plays a large role because it will determine how many prospective buyers might be interested in your company and what their characteristics might be. A company with revenue less than $1 million and EBITDA less than half a million is likely a primary target of another owner-operator. In contrast, companies with EBITDA of $2 million or greater may attract a number of buyers including private equity. Once the buying pool for your company increases, so will the multiples for your business.

Is Five-X Grounded in Reality?

Let’s circle back to the original premise of this article about how five times EBITDA is somewhat of a myth. Yes, there are businesses in the Middle Market that can sell at five-times EBITDA or more, but let’s take a look at who they are. Based on a review I did recently using Business Valuation Resources’ DealStats, if you were a manufacturer, you’d have to generate revenues north of $5 million for an average company to generate multiples in the fives. For manufacturing companies smaller than $5 million of revenues, five multiples are mostly earned by above average companies. If you generate less than $1 million in revenues, five multiples were earned only by best-in-class companies. Keeping in mind that most companies listed don’t sell, being an above average company or best-in-class is not an easy task.

Most businesses aren’t transferable. For those that might be, they have issues they need to address.

This means that for most businesses, five times EBITDA isn’t realistic, especially if they have not undertaken any form of value creation program. In fact, a company that is “barely transferable” will likely receive EBITDA multiples of 2x to 3x. This can come as a shock to a business owner who has been dreaming of five multiples based on what they heard they can get at their local golf course.

Growth & Exit Planning

If you are business owner, should you be discouraged? No! Holistic exit planning is a process that embraces both value creation (improving the business, making it more attractive, and ultimately more valuable) and exit readiness on the business and personal side. Given enough runway to exit, and enough will power to make it happen, a business can move from nontransferable to transferable, and lower value to higher value. This is why I always suggest three to five years is the minimum time frame to start thinking about planning an exit.

Waiting until you list your business for sale to only find out it is below average isn’t a sound proposition. Take the time now to assess your business readiness, develop a game plan to improve your company, and be more exit ready. Even if you have no defined exit timeline, you’ll be a position to create a company that is attractive and can sell for above average multiples. Given how much wealth is tied up in your business, don’t you owe it to yourself and your family?