Valuing Your Business
Getting Approximate Value Is Surprisingly Easy!
This is a million dollar question for the seller – and a rough answer is usually surprisingly easy. However, when you google to find the answer, most of the time you find a long essay talking about various valuation models (e.g. Income Approach, Market Approach, Cost Approach).
All of the above methods are indeed used for more thorough valuation, but in practice a majority of buyers (and banks who fund them), follow a very simple method in valuing a profitable business – which is either a multiple of EBITDA or a multiple of Discretionary Earnings (DE), also known as Seller’s Discretionary Cash Flow or Seller’s Discretionary Earnings (SDCF, or SDE). EBITDA is typically used for a business of reasonable size (say over $1 Million in revenue), whereas the DE is usually for smaller and typically owner-operator types of businesses where the owner of the lab is fully involved in the day to day operations.
EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization (yes, it is a mouthful). But essentially, you take the net earnings of the business, add back the interest expense, state and federal income taxes, depreciation and amortization and you get the value of EBITDA. In practice, we always use Adjusted EBITDA rather than ‘pure’ EBITDA, because in small businesses often there are “discretionary expenses” that are not business-related and also one-time expenses, such as certain amount of capital expenses which are typically not usual expenses but are expensed out in one year, instead of being on the balance sheet, for tax benefit. Examples of Discretionary Expenses are higher than market salary for the owner, personal car on the company expense, owner’s wife or son on the payroll even if they are not involved in the regular work. So these are called “add-backs”, because these are added back to the EBITDA to provide Adjusted EBITDA.
So once you have this magic Adjusted EBITDA number, you can approximately estimate the value of your business by multiplying this EBITDA by a multiplier. This is where it gets a bit interesting. For example, for a small business with revenues of say between $1-$5M and EBITDA under $1M, the multiplier is typically between 2.5-5 but usually between 3-4. Depending on the type of the business, it could be higher or lower than this range or on the high end or low end of this range. Some of the factors that decide where it will fall, are discussed in the section for Sellers and determining your Value Builder score. But the most important thing to remember is that a right value is what at a given time, a buyer is willing to offer, depending on how badly he or she needs it.
Also remember that as the size of the business becomes larger, it also attracts higher multiples – EBITDA multiples could go up to 5-8 for businesses that are much bigger in revenues and EBITDA, or sometimes even much higher if your business is of strategic importance for a strategic buyer. Remember the famous saying – value is in the eyes of a beholder. A buyer who is not able to capture some customers because he or she lacks certain capabilities, geographic presence, or certification, could easily pay a premium for a certain business, and for that buyer, the price is justified.
What about smaller businesses that are owner-operated and use DE or SDCF instead of EBITDA? DE or SDCF in simple terms is EBITDA plus owner’s compensation and the valuation multiple is typically for DE is in the 2-3.5 range.
EXCEPTIONS TO THE RULES
Of course, there are several exceptions to this general valuation method. Some businesses may be very fast-growing and may have something unique or something proprietary and can be an exception to the rule. And it is tricky for businesses that have small, zero, or negative EBITDA.
For example, for a business that has a very small, zero or negative EBITDA, obviously, we cannot use the above method. We have to look at the value of the assets – assets could be hard assets such as equipment and inventory, could be employees and the turn-key nature of the business, licenses or contracts that are hard and time-consuming to get.
Such businesses are not easy to value – for example, some licenses could be very valuable to someone who needs these badly and could be worthless to others. It all depends on supply and demand.