It’s Elementary! Use simple math to enhance the value of your business.
Determining the value of your business is pretty easy math, right?
It is simply,
Cash Flow (or Revenues) X Multiple = Enterprise Value
So, if it is simply a formula, why is it so hard and costly to determine the multipliers, Cash Flow (or Revenues) and the Multiple? There are several reasons why. Let’s take a look:
Show me the Money!
Revenues are used to value a business, but not as often as you might think. Why? That’s easy – revenue does not always translate to cash flow. For example, let’s say you have two businesses both making $50m in revenue.
Company A generates net income of $5m annually or 10% of revenues.
Company B generates net income of $1m or 2% of revenues.
All else being equal, would you pay the same price for both? Absolutely not!
A more common measurement of value is Cash Flow or EBITDA - earnings before interest, taxes, depreciation and amortization. We won’t go into specifics here on how this is determined, but going back to the example above, which company would you be more likely interested in buying?
Company A, generating $5m in net income annually or
Company B, generating $1m annually?
The one generating $5m, of course. This is why Cash Flow or EBITDA is most often used in valuing a business.
For most SMEs (small, medium enterprises) the challenge lies in determining the EBITDA to be used. Think owner perks, nonrecurring and extraordinary expenses, and other discretionary expenses etc. It is important to analyze the financial information and add these items back to determine the “real” cash flow of the business.
This can take time and money.
Multiple: It’s not what you think!
I often hear business owners say, “Well, my buddy got a 10x multiple for his business, so certainly I can get that too.” Not true. In fact, multiples vary by industry, geographic market, company and even by the economic conditions at play. While you can’t control some of these factors, you can control the impact your company has on the multiple. Let’s take a look at two companies - both with the same EBITDA ($5m).
Company A has a wide customer base, strong management team, and documented processes and procedures and
Company B which relies on a major customer for 30% of its business, has no management team and undocumented processes and procedures.
Which company do you think will be able to command a higher multiple, all else being equal?
Company A, of course!
What you do to impact the multiple your company commands varies, with some measures impacting value greater than others. Some will be easier to implement than others. Most will require a investment of time and money. But with the help of the right professionals, the changes, in some cases, can double the value of your company.
Key Takeaways
While valuing a business may be a matter of simple math, determining the multiple to be used and the cash flow to apply the the multiple to is not always that easy. But as a business owner, you can have an impact on driving value in your business.
You have two options:
Enhance cash flow or
Do the things you need to do to command a higher multiple.
Improving one of these can increase the value of the business, but if you are able to increase both it can have a significant impact.
Stay Tuned!
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ETS Compass is my personal newsletter that provides thought-provoking topics and helpful guidance to business owners looking to navigate change in their businesses. Whether it is value enhancement or transition planning, it is my goal to educate you.
My goal is to provide useful and purposeful information to you that may help you transition from your business.
Author: Sheryl Brake
Sheryl is the CEO and Founder of Encompass Transition Solutions, LLC and former partner of a top 25 national accounting firm. She has been working with business owners in a wide variety of capacities for more than 30 years. Sheryl lives in her home state of Colorado with her husband, Michael.