What Multiple Will Your Business Trade On?
The more knowledge you have about the value of your business, the more informed your business decisions. This article has two objectives. First, to provide background and context as to what a business multiple is. Second, to explain different multiple cases and considerations so that you can identify which multiple is most applicable to your business. Learning about multiples and how they represent business value will inform your business strategy and decision-making process.
A “Multiple” is a particular word in the world of business finance. It is a simple way of discussing and representing a complex set of analyses and investment models. At its heart, a multiple is a straightforward way of discussing the present-day investment value of a business by describing it as a number “the multiple” that can be directly applied to a current operational metric. We will get into how that number is determined a little bit later in the article.
It is customary in lower middle market M&A that the buyer determines the value of your company, not the seller. Isn’t that interesting? Why would a buyer determine the value of the seller’s business? There are many factors at play in this process. It helps if you consider this as an investment rather than as a sale. The investor establishes a value based on their perception of how the business will cover the required return.
This methodology of making buyers “bid” in a limited blind auction environment (a marketplace where there are multiple buyers bidding on the same business without knowing what the other bids look like and the best complete offer will win) creates favorable market conditions. It compels the buyer to become serious about delivering a competitive and fair value for your business. They have to consider the financials, employees, assets and have a good view of the entire company, and only then, do they create an offer.
The more a buyer reviews the salient attributes of your company, the more likely they grow to imagine themselves at the helm. They begin to contemplate the changes they would make and how their involvement will lead to new growth. The offer is a statement of their perception of the growth opportunity coupled with the risk inherent in achieving it. Circling back, the multiple is actually the inverse of the risk that a buyer places on a business that he/she looks to invest in. This risk is addressed as a multiple of historical performance to create a shorthand estimation of the anticipated payback period for the investment.
Armed with this understanding of what multiples are, we can begin to discuss the most common ways in which they are applied. Multiples are typically applied to elements of the income statement, so you will hear about a multiple of revenue, gross profit, or EBITDA. A company trades on a multiple of revenue when it has a high level of reoccurring revenue. An example of this is Netflix, which has a monthly subscription making revenue the primary driver for all operational decision-making. Businesses that trade-off of a multiple of revenue do so because all organizational risk can be directly attributed to changes in revenue. Other examples of multiples of revenue companies are Microsoft Office, Hulu, or any other type of Software as a Service.
A multiple of gross profit is another unique case for valuation and is typically reserved for transactions where a division is carved out of a larger operation or where a synergistic operation acquires a competitor. In these instances, the operating expenses (frequently referred to as SG&A) are irrelevant to the acquiring organization so the risk/multiple is applied only to the pertinent portions the revenue and the cost of goods sold.
Most businesses are not traded on a multiple of revenue or of gross profit. Any company that is not driven by regularly recurring revenues will be valued on the basis of its ability to deliver cash flow. Most organizations do not track their statements of cash flows opting instead to manage against their income statements (also called P&Ls) and balance sheets. For this reason, a shorthand proxy for free cash flow called EBITDA (earnings before interest, tax, depreciation, and amortization) was developed. If someone talks about a business multiple without any other qualifier, it is a safe bet that they are referring to a multiple of EBITDA. One more convention used in the case of smaller businesses being sold to a buyer who will also be operating the business after the sale is SDE (seller’s discretionary earnings) which is simply EBITDA plus the owner’s salary. This is simply a reflection of the free cash flow of the company as a true pass-through entity.
Learning the language of business means that you can better understand what questions to ask other business owners and your Trusted Advisors. What multiple are you trading in? What factors are buyers looking at? It only increases your business savvy. Understanding how to correctly consider the value of your company will allow you to make the best moves for your business. If you now realize your company should not trade on a multiple of revenue, then look into the EBITDA and SDE methods. Most of all, this should give you the peace of mind that your business is unique and requires a different valuation to understand your business’s value.