There are many techniques used to estimate business value, but the technique most familiar to small business owners is the multiple of EBITDA represented by this basic formula:
EBITDA x Multiple = Business value
The formula is simple, but widely misunderstood. We often hear business owners say things like “My competitor just sold her company for 6 times EBITDA, so my company must be worth 6 times EBITDA also.” Or “Companies in my industry typically sell for 4 - 8 times EBITDA.” The owner then does a mental calculation of their business’s value, usually using the most aggressive EBITDA multiple, and “the number” becomes the presumed sale price. And it’s almost always wrong.
We’ve worked with scores of business owners to plan or execute the sale of their businesses and one of the first things we do is establish a realistic current business value. The valuation we develop is often quite different from what our clients have calculated on their own.
In this article, we’ll explain how to use the multiple of EBITDA formula more accurately. This article is not a substitute for engaging a valuation professional, but it should help to make those rule-of-thumb calculations more realistic. There are three parts to using the multiple of EBITDA valuation method.
Part 1 will demonstrate how the EBITDA on your financial statements is adjusted for valuation purposes.
Part 2 involves selecting the right EBITDA multiple for your industry and your company.
Part 3 describes how business valuation is modified for company debt levels to create a business sale price.
Throughout this article, we’ll use a fictional company named ACME Manufacturing to illustrate our points. We’ll assume that ACME Manufacturing is operated by two founders. In the last twelve months, it had $25 million in annual revenue and $1.3 million in EBITDA. We’ll learn more details about ACME’s business as we work through this valuation exercise.
PART 1: UNDERSTANDING ADJUSTED EBITDA.
Business Valuation Reporting Period.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a common way to evaluate the operating cash flow of a company. When valuing a business, it’s customary to use trailing 12 month EBITDA. In cases where a company has seen unusual increases or decreases in EBITDA over the past few years, it may be more appropriate to use an average of EBITDA over that time period. It’s important not to cherry-pick the time period if you want a realistic valuation. Regardless of which period is used, there’s an important step in valuation calculations that’s often overlooked: “normalizing” or “adjusting” EBITDA.
EBITDA Adjustments or Add-Backs.
Adjustments to EBITDA are designed to help a would-be buyer evaluate the company’s cash flow potential under their ownership. Adjustments are made to account for any unusual revenue and expenses that are unique to the current owner’s management of the business. Adjusted EBITDA is usually, but not always, higher than the EBITDA that your accountant calculates on your financial reports, so it’s important to adjust properly.
Owner Compensation Adjustments.
The first adjustments to EBITDA center around the compensation paid to owners. If the owners are drawing higher than market salaries, the difference between actual and market salaries would be added back to EBITDA (e.g. The company would show higher profit if owners drew lower, market-level salaries). Similarly, if the owners are drawing below market salaries, EBITDA would be adjusted lower to reflect what it would really cost to pay the owners team at market salaries. Remember, the objective here is to help a would-be buyer understand the cash flow of the company under their new ownership which may involve hiring staff to replace the current owners.
Owner compensation includes all owner “perks” as well. For example, owners often run personal expenses (e.g. car, country club, personal travel, etc.) through the company to reduce taxes. EBITDA needs to be adjusted (increased) for these expenses, as the new owner may choose to manage these items differently.
Fair Market Real Estate Adjustments.
Another common area of adjustment occurs when the business is renting real estate from a separate but related company. For example, if there is a separate entity with overlapping ownership that owns the factory or office building the company occupies, the rent charged by that separate entity may be above or below market value. If the company being valued is paying above-market rent then the difference between market rent and the actual rent paid is added back to EBITDA. (e.g. the company would show higher profits if it were paying market rent). The reverse is true if the company is paying below market rent.
Non-Recurring Revenue and Expense Adjustments.
Other adjustments to EBITDA include non-recurring revenues or expenses (e.g. one-time changes to accounting methods, relocating the business, unusual litigation expenses or gains, the sale of assets, etc.). The full range of these potential adjustments is beyond the scope of this article, but the example below should illustrate the EBITDA adjustment process:
Adjusted EBITDA Example
In the example above, the Adjusted EBITDA for the year is $635,000 higher than the EBITDA reported on an income statement. Companies ACME’s size often trade at multiples of between 4 and 8 which means, adjusting the EBITDA added between $2,540,000 ($635,000 x 4) and $5,080,000 ($635,000 x 8) to the valuation - a pretty big difference!
PART 2: SELECTING THE RIGHT EBITDA MULTIPLE FOR YOUR INDUSTRY AND COMPANY.
In part one we described the difference between the EBITDA reported on your accounting statements and the adjusted EBITDA used in valuation. In this part, we talk about the factors that influence the multiple that is applied to adjusted EBITDA to determine company value.
The table of median EBITDA multiples, below, represents a reasonable starting point for determining the multiple for any company based on its size and industry. The median multiple for our fictional manufacturing company with adjusted EBITDA of $1,935,000, is 5.5.
Median EBITDA Multiples by Industry and (Adjusted) EBITDA range.
Extracted from the 2024 Private Capital Markets Report produced by the Pepperdine Private Capital Markets Project.
Having a median EBITDA multiple for your industry and company size is useful, but it’s important to recognize that the actual EBITDA multiple applied to your company by a potential buyer can vary widely based on their perception of the risks versus rewards of buying your company.
Buyers will evaluate a variety of factors to determine the EBITDA multiple that will serve as the basis for their purchase offer. Here are some of the most important factors:
Bigger Companies Have Higher EBITDA Multiples.
It's a fact that companies with higher revenue and earnings trade at higher multiples than smaller companies. When it comes to business valuation, bigger is better, all else being equal, and that is reflected in the median multiples table above.
Unique Competitive Advantage Means Higher Multiples.
Acquirers generally buy what they cannot easily create themselves, so expect a higher EBITDA multiple if you have a distinct competitive advantage in the marketplace. This often comes from intellectual property in the form of patents, know-how, and/or exclusive rights to a specific product or service in your market. These competitive advantages generally translate to higher profits and thus higher values in the adjusted EBITDA portion of your valuation, but they will also impact your multiple if a potential acquirer believes these advantages can be exploited on a larger scale under their management. Innovation and intellectual property, more than any other criteria, have the ability to drive above average multiples and valuations.
Revenue and Profit Trends.
Revenue and earnings trends are almost as important as the numbers themselves. For example, we’ve shown that ACME Manufacturing has $25 million in revenue and $1,935,000 in adjusted EBITDA, but we haven’t looked at trends. If ACME has been growing at 20% per year to arrive at the current performance, the EBITDA multiple is likely to be adjusted up. On the other hand, if revenue and earnings have been stagnant, the multiple might be adjusted down. Buyers will pay for momentum and the likelihood of future growth. Declining businesses are viewed as especially risky and they will be discounted, sometimes heavily.
Recurring Revenue Increases EBITDA Multiples.
The stability of recurring revenue streams reduces the buyer’s risk, and their annuity-like value may help the buyer to obtain more attractive acquisition financing. Whether your customers are locked in via long-term contracts or they have simply established a long history of choosing your products or services over others, recurring revenue translates into higher EBITDA multiples.
Industry and Location.
Valuation multiples vary by industry (as demonstrated by the table above) and also by geography. Companies in fast growing industries and/or fast-growing regional economies command higher EBITDA multiples than those in stagnant or declining industries and/or economies. Similarly, companies near major metropolitan areas with access to larger markets and more employee talent, tend to have higher multiples than similar companies in rural areas.
Business Owner Dependence.
One of the most common barriers to selling a smaller company is excessive dependence on the owner(s). Successful founders tend to be smart, demanding and very hard-working. The traits that allow a founder to power through the many obstacles to building a company can make it difficult to delegate, and to develop an empowered management team. Buyers view over-dependence on the owner as a risk. A sale transaction will probably provide the seller with a “life-changing” sum of money. Will he or she stick around and be able to check their ego sufficiently to work with the new owners? Buyers worry about these things and they will pay more for a company if it’s not overly dependent on the owner(s), if it has a solid management team, a trained staff and well-established business processes.
Customer and Vendor Concentration.
How dependent is your business on a small number of customers or vendors? In the eyes of a buyer, dependence equals risk and lowers business value. If one customer is responsible for 25% of your business or if you have a sole source vendor for a critical part, a buyer is going to discount their valuation of your company. In cases of extreme customer concentration (e.g. 50% of your revenue from 2 or 3 customers), it may be difficult to attract buyers no matter how profitable the company is.
Accounting Practices.
Accounting is the language of business. If your accounting systems are well-organized and consistent, then everything from calculating adjusted EBITDA to measuring recurring revenue will inspire buyer confidence. Quality accounting is expected. Sloppy accounting introduces uncertainty and risk, and lowers EBITDA multiples.
Applying risk factors to ACME Manufacturing.
In our example company, ACME Manufacturing, we would analyze each of these factors to identify business risks and advantages, to determine whether an appropriate multiple would be higher or lower than the median multiple of 5.5. In the example below, we look at two extreme scenarios for Acme manufacturing; one where the company scores poorly and one where the company scores very well.
Example of How Business Risk Factors Can Impact EBITDA Multiple.
These examples illustrate how much the valuation for a specific company can vary from industry norms based on that company's unique characteristics. In both examples, the adjusted EBITDA is $1,935,000, but "Strong Acme" would be valued at 10x or $19,350,000 and "Problematic Acme" would be valued at 2x or $3,870,000.
Determining a reasonable multiple is always a subjective process. Indeed, each prospective buyer may arrive at a very different answer. It's important to anticipate the buyer's likely view of valuation as part of your business sale planning process. It’s human nature to be optimistic about your company’s value, but it’s dangerous to build an retirement plan based on that optimism.
As we move forward with our ACME Manufacturing example, we’ll assume that the company has some challenges that reduce their multiple from the industry median of 5.5 to 4.5.
PART THREE: THE DIFFERENCE BETWEEN BUSINESS VALUE AND SALE PRICE.
By now, you may have noticed a problem with our valuation formula - it doesn’t take company debt into consideration. That’s because the multiple of EBITDA formula is used to estimate a company’s Enterprise Value.
Enterprise Value vs. Business Sale Value.
Enterprise Value represents the total value of a company, including its value to shareholders and debt holders. It reflects the value of the entire capital structure. Enterprise Value is a useful tool when comparing companies with varying debt levels, but debt levels do impact sale prices.
Impact of Debt on Business Sale Value.
Imagine two companies with the same adjusted EBITDA and EBITDA multiple, but one has significant long term debt and the other has none. Using our formula, both would have the same Enterprise Value, but would you expect both companies to have the same sale price? Of course not.
For simplicity, let’s assume that ACME Manufacturing is sold in stock sale - a full transfer of the legal corporate entity including all balance sheet account balances.
To estimate the shareholder value in a stock sale, we need to subtract long term debt from the Enterprise Value we calculated using our multiple of EBITDA formula.
In our ACME Manufacturing example, we established the company’s adjusted EBITDA as $1,935,000 and its multiple as 4.5. ACME’s Enterprise Value would be $8,707,500 (adjusted EBITDA X 4.5).
Let’s also assume that the company has long term debt of $4 million. The purchase price in a stock sale would be adjusted to $4,707,500. ($8,707,500 in Enterprise Value minus $4 million in long-term debt) to account for the buyer's assumption of debt. Even though a buyer acquires all assets and liabilities in a stock sale, the value of that stock will be established based, in part, on the amount of long term debt being assumed.
Business Valuation Rules of Thumb Can be Misleading.
It's tempting to estimate a business' potential sale price based on valuation rules of thumb that are cited throughout industry, but as we've shown below, they can be very misleading. Simply multiplying Acme Manufacturing's stated EBITDA of $1,300,000 by the median EBITDA multiple for a business of that size and type would have suggested a value of $7,150,000. As we've seen, however, the Adjusted EBITDA was significantly higher and the proper valuation multiple was somewhat lower than the median multiple. And, of course, there is long-term debt to consider.
For most business owners, their companies represent their largest asset by far. Developing a realistic estimate of the business' value requires the proper use of valuation techniques. Imagine how different the ACME owner’s exit plans might be if they based them on an assumed sale value of $7,150,00 instead of the more realistic value of $4,707,500.
We hope this example has given you a better understanding of one of the most common methods for estimating business value - the multiple of EBITDA. Even with this new understanding, there are two very important things that business owners need to keep in mind:
1) Producing an accurate business valuation requires an objective assessment of the company and an understanding of the broader merger and acquisition market. There is no substitute for professional, objective valuation assistance when making important business sale decisions.
2) Professionals can provide reasonably accurate valuation estimates, but they are still estimates that include a degree of subjectivity. The ONLY way to know the actual value of a business is to offer it to a broad array of potential buyers with proper planning, effective marketing and experienced guidance. Ultimately a business is worth whatever a buyer will pay for it.
About Venture 7 Advisors:
Venture 7 Advisors is a team of merger and acquisition advisors who assist the owners of small and mid-sized companies to plan and complete the sale of their business. We find the best buyer to meet each business owner’s financial and legacy goals. We represent clients in consumer products, distribution, manufacturing, B2B services, construction, telecommunications, and eCommerce from offices in Burlington, Vermont, the Hudson Valley, New York, and Western Massachusetts.
We're here to talk about your situation, provide information, discuss your options, and put things in perspective. Contact us at any time:
Bryan Ducharme
Managing Partner
Mobile: 802 578 6462
Scott Hardy
Partner, Master Entrepreneur