The Art and Science of Determining a ‘Multiple’

Selling a company can be a complex and emotional experience, complicated by a number of factors such as unfavorable economic conditions, reluctance to let go of a business the owner has built or unrealistic expectations regarding the likely selling price. 

But working with a valuation professional who can manage expectations and provide guidance as to how to prepare the business in a way that adds value can lead to a resolution that satisfies all parties. The best outcome in any business sale happens when the deal is closed with the right buyer and terms and conditions that everyone feels good about.  

Getting to that point starts with a business valuation. There are several value drivers in a company, most of which can be defined as qualitative and quantitative factors.  

Qualitative & Quantitative Factors 

Qualitative factors can include such elements as the company’s core business, quality of management, customer groups, competitive advantage, technologies, market share and industry growth trends. Valuation that’s attached to qualitative factors typically is reflected in the multiple that is applied to arrive at the selling price and can influence the valuation methods utilized. 

The quantitative side typically comes down to cash flow. Buyers in the middle-market privately held business sector are heavily focused on cash flow; hence, most valuations in that market segment are based on future projections of cash flow. 

There are several methods used in business valuations, and the strongest approach for the middle market is to find a relevant market multiple.

The most commonly used is a multiple of EBITDA – earnings before interest, taxes, depreciation and amortization – a calculation that is considered an indicator of the overall profitability of a business. Determining the multiple involves looking at several other factors, including comps. 

A valuation professional will look at recent transactions involving businesses that are as similar as possible to yours and learn what buyers paid to determine comparable prices. Additionally, they will determine if there are unique features in a business that should be considered when reaching a multiple. Is the industry or the company volatile? Is the marketplace highly sensitive to interest rates or other economic fluctuations? Is the company in the best condition to demand a high multiple? 

Once it is determined, the multiple becomes a data point used in price negotiations. 

In addition to determining the multiple, a valuation professional will look at cash flow. Cash flow will help accurately portray future cash flows and paint a picture of what the business will look like after the sale. It is not the only measure of a company’s value; however, buyers and sellers alike must understand the shortcomings of any single data point in determining a company’s value. Even a company with lackluster cash flow can look good if it is outperforming its industry in other areas. 

Getting to the Valuation 

Reaching the valuation requires a detailed analysis of the business’s financial performance. This typically involves looking at three to five years of financial data and backing out any non-recurring items, including discretionary expenses, the selling owner’s salary and any extraordinary costs such as those related to the COVID-19 pandemic. This is known as “normalizing” the financials. Once the financials are normalized, the valuation professional can run projections that will drive the valuation. 

If the seller has a specific selling price in mind that the valuation must support – say $10 million – and the market shows that buyers are willing to pay that or more, everyone is happy. But if the market for the business is paying less – say $8 million – it’s time to look for gaps. Where can improvements be made in the business to push the market value to $10 million? Are there qualitative factors that can be emphasized to potential buyers to entice them to pay more? Is the business outperforming its industry?  

In many cases, the selling owner will offer to stay on with the company for two to five years as a salaried employee and function as an internal consultant. Hence, the deal is structured at a selling price of $8 million, with a $2 million salary payout over the next few years, based on performance. 

When valuing a company for sale to outside buyers, an analysis of likely buyers or buyer groups in the company’s industry and geographic region helps in getting to the right numbers. A $20 million manufacturer of machine parts in the semi-rural Midwest may not be valued the same as a $20 million machine parts manufacturer in an urban area of the Southeast U.S. There are many factors at play, including labor availability and prevailing wages, but buyer groups are also different in those locations and may not tolerate the same valuations. A valuation professional will take this into account and adjust the valuation range accordingly. 

Variable Influences 

Variable influences that are often temporary can impact business valuations, sometimes significantly. So business owners who are thinking of selling need to consider the current business and economic climate before going to market.  

Currently, high interest rates are negatively impacting the merger and acquisition market. While there is demand on both the sell side and the buy side, the cause for concern is on the buy side since almost every deal is financed either through a bank or a private equity group. Consequently, acquisitions that were affordable two years ago are today much more expensive, and banks are tightening up their underwriting standards. The impact of high interest rates is particularly heavy in the smaller and middle-market deals, where a buyer paying $5 million for a company may end up with half their cash flow going to debt service. 

Another variable factor in some valuations is the uncertainty about what may happen with the federal estate tax exemption, which is scheduled to be reduced significantly after Dec. 31, 2025. This could have a major impact on valuations in cases where owners are selling or otherwise transferring their businesses to younger family members.    

Finally, marketplace and economic factors come into play. There is still demand for businesses of all sizes and types. Moreover, it’s easier to buy a business now thanks to technology, resources and years of development. There are more options now than ever. While interest rates and the economy may curb some supply that will likely be offset by the Baby Boomers’ transfer of wealth, which is underway and is accelerating. 

If you would like to discuss a valuation for your business, contact an Adams Brown business valuation advisor.