This is a brief guide to business valuations for the lower middle market. For a more complete guide please obtain the Valuation Guide using the form.
The diagram below is a Compass Point variation on the “rules-of-thumb” valuation metric for lower middle market businesses (businesses with earnings between around $500K and $20 million). The very basic and rough rule of thumb valuation for a company with around a million or more in earnings is a value of 5 times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Why five? Because the average selling price for many businesses turns out to be 5x EBITDA (lower for companies under one million in earnings). Do middle market buyers really just use a multiple of five when buying a business? No, they will perform extensive analysis and run financial models for every deal. However after all the analysis and models, some deals end up below five, some above, and the average has remained around five.
Which brings us to the valuation chart. Why are some deals more than 5x, and some less? Here’s the guide:
What the chart says is this:
The 5x base value assumes the company has a stable history of performance and has no significant blemishes. A stable financial performance is the most basic component, the foundation of a valuation.
EBITDA can be enhanced by a buyer that can reduce costs and take advantage of other synergies, and because of that the synergistic buyer can afford to pay a little more for the company. They will not want to, of course, but with a competitive situation and negotiation they usually will.
A strategic buyer that can go further and take the company to a new level of sales growth and open up new opportunities (usually as well as the cost synergies, above) can afford to pay even more. Note that it still comes down to financial performance and earnings, but the strategic buyer is betting they can pay now for later earnings. Unfortunately, the true strategic buyer that will pay a substantial premium is somewhat rare.
However, nothing’s perfect and I’ve yet to run across the perfect company. There are always blemishes, and if serious enough to cause a risk that future earnings may not actually turn out as expected, then these blemishes work to pull down the valuation. Do you have one customer (or supplier) that contribute more than 25% of your revenue? Messy financials? Lots of adjustments (addbacks) to the earning? These can pull that 5x multiple down to a 3x. Or if you have a strategic buyer, perhaps they’ll only pay a 5x.
A professional valuation uses a similar process to the guide by taking a close look at your fundamental performance (e.g. discounted cash flow approach to valuation) and/or looking at whether your particular market has a history of strategic buyers (e.g. the market approach to valuation), and then they discount the value based on the some of the risk factors they find.
If you can stand back and take an objective look at your business, you should be able to estimate a multiple for your business.