Companies Sell for a Multiple of…What?

Last week we discussed the difference between Main Street and Mid-market companies regarding their prospects for finding a buyer. You can read it here, but the short analysis is that the market is tightening for Main Street businesses, while the number of buyers and valuations for Mid-markets are at or near an all-time high.

The confusion between the two regarding valuation methodologies is even worse than that surrounding potential buyers. Owners and their professionals talk about earnings, add-backs and recasting financials as if they were universally accepted terms. They are not, and their usage differs dramatically between the two types of companies.

Despite this, I frequently (and I mean with something close to half the cases I work with) see professionals (who should know better) toss out valuation multiples like they were written in stone somewhere. CPAs seem to be the biggest offenders, but attorneys run a close second. They casually tell a business owner things like “All small businesses sell for about 5 times earnings,” or “You can expect your company to bring between 3 and 4 times its adjusted cash flow.”

They seem oblivious to the fact that an owner takes their uninformed and uneducated off-the-cuff statement very, very seriously.

No two companies are alike. Besides profitability, growth rate, customer concentration, management depth and geography, valuations can vary by as much as 40% with the swings in the financial markets. There is no “typical small business value,” but how companies are valued is pretty consistent in the two segments.

Let’s start with a high-level view. The buyers for Main Street (under $3 million valuation) businesses are typically purchasing a personal income stream. Those acquiring a Mid-market company are seeking return on investment, whether from profits or potential growth. Therefore, the two look at expenses and cash flow differently.

Main Street: When preparing a smaller business for sale, a broker will “recast” some expenses on the income statement. Recasting starts with profits before taxes, and adds interest expense, depreciation and amortization. The first add-back, interest, is assumed to be a cost of growing the business, and one which an owner could avoid if he or she chose to. (If you are borrowing to cover losses, you company probably isn’t saleable anyway.) Depreciation and amortization are non-cash methods of accounting for tax purposes, and are considered available cash flow.

The rest of the recasting involves those items that are “Sellers Discretionary Expenses” (SDE). Put politely, they are the type of expenses that the seller would probably not be able to take in someone else’s business. They can range from a personal vehicle to transporting the family “Board of Directors” to Orlando for an annual meeting.

These expenses are added to the owner’s salary and benefits to give buyers a better picture of all the financial benefits of ownership. Valuations are different for every company, but when a business is being sold to an individual owner-operator who will use third-party financing for the majority of the purchase, the ability to draw a salary and support the debt keeps valuations for such companies at an average of 2.2 to 2.8 times the SDE. (I repeat- your results may vary, but these are the averages.)

Mid-Market: These buyers don’t really want to see a bunch of hidden benefits. It’s too hard to explain to their investors or corporate executives. They assume that the owner’s compensation package is in line with what they will have to pay a new president to run the company. Except for some GAAP adjustments, their add-backs to cash flow will include Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).

Falling back on averages again, multiples of EBITDA paid by private equity groups from about 2003 to 2013 ranged year-to-year from 4.7 to 5.2 times “earnings.” Not a very big range, and not surprising considering that they have investment return targets for every deal.

Which one is better? Neither. Both. It doesn’t matter. I’ve seen plenty of companies where 2.8 times SDE was more than 4.7 times EBITDA. It’s just the way the two markets measure.

It is important, however, if you are preparing your company for a third party sale. Many advisors tell their clients to strip all personal benefits out of the company years before selling in order to raise historical EBITDA. That is far more important if you are selling a business worth over $3 million, but usually in such businesses the personal benefits aren’t really material. In a smaller business, most of those expenses will be recast anyway.

Just understand which methods apply to your business. If you are working on an assumption that  your buyer will “typically” pay 5 times SDE, you have mixed apples and oranges, and are likely heading for disappointment.