Anyone who has considered buying or selling a lower middle market business quickly becomes familiar with the term “multiple of adjusted EBITDA,” where valuation is based on a multiple of the business' earnings before interest, taxes, depreciation and amortization.
In this article we'll look at the underlying principles that drive the range of multiples an entrepreneur can expect to receive when selling a business, and address how adjusted EBITDA is calculated.
Understanding Valuation Multiples
The appropriate multiple for any particular business can vary, with higher EBITDA multiples paid for more attractive businesses, and lower multiples for less attractive businesses.
Take hypothetical Business A and Business B, which each generate $4M in adjusted EBITDA. Let's say Business A sold for a 4x multiple, or $16 million; and Business B sold for a 6x multiple, or $24 million.
If you can buy Business A for $16 million, why would anyone pay $24 million for Business B, when they both generate $4 million in EBITDA? Was the $16 million business a bargain? Or was the $24 million business overpriced?
Both are possible, given the limited price transparency in lower middle market transactions. But let’s assume that the businesses are priced correctly.
As a first step, consider the multiple in terms of rate of return on each investment. The implied expected rate of return on the investment is the reciprocal of the multiple.
· Business A, with a 4x multiple, implies an expected annual return of 1/4 or 25% per year. A buyer who pays $16 million for Business A is expecting an annual rate of return on their investment of 25%, assuming the business continues to generate $4 million each year.
· Business B, with a 6x multiple, implies an expected return of 1/6, or 16.6% per year. The buyer for Business B at $24 million is expecting an annual rate of return on their investment of 16.6%, assuming that business also generates $4 million per year.
The implied return is correlated with risk and the potential long-term increase in value of the investment.
Lower valuation multiple and higher return = higher risk. Higher valuation multiple and lower return = lower risk.
The pricing of Business A and B implies that the business with the highest expected return (and lower valuation multiple) Business A, has a higher risk profile than the business with the lower return (and higher valuation multiple) than Business B. To be compensated for taking on more risk, a buyer would pay less for it. Business B is less risky than Business A, and therefore the buyer would pay more for it and / or be satisfied with a lower rate of return.
As a seller, figuring out how to reduce risk (i.e., the chance that income will decline in your business) can help generate a higher valuation multiple.
Let’s look at some factors that reduce perceived risk (and increase multiples) in lower middle-market businesses. They include:
Conversely, factors that increase risk (and reduce multiples) include:
These are just a few examples, and you can probably think of many more factors that increase or decrease risk. This type of analysis also helps us understand why some industries generally receive higher multiples than others.
While this overview seems simple, each transaction typically has additional layers of complexity. For example, buyers often bring synergies to a transaction that can reduce the risk in a business. Or when leverage is involved, the buyer generates a higher return on their capital invested. Finally, actual terms on the transaction are not always completely or accurately tied to risk and performance of the business. Not every seller or buyer has adequate information or reasonable expectations regarding the price of a business given the level of risk involved. Some sellers may be more motivated than others, and the external economy and demand for investment opportunities also drive buyers’ willingness to pay higher prices.
Another additional consideration and implication for valuation multiples is anticipated future growth. We will address this in a future article.
Understanding Adjusted EBITDA
Now that you understand how multiples work, let's look at what goes into adjusted EBITDA. As you may know, EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization.
As a rough guide to calculate EBITDA, take net income and add back line items for interest, taxes (corporate Federal and state income taxes only, not payroll taxes or sales taxes), depreciation and amortization. This is EBITDA.
Now you can make "adjustments" to EBITDA. These are to normalize your income to adjust for excess or below market owner compensation, and other one-time events.
For example, let's say that you're a C-Corp and for tax purposes, you're paying yourself a nice salary of $800,000 per year. A new buyer likely will not pay a new CEO $800,000 a year, so you can adjust this down to a market salary. Let's assume that is $200,000. This means you can reasonably add $600,000 in adjustments to EBITDA. Note you cannot add the whole $800,000 in your salary because EBITDA assumes a reasonable owner salary is included in the expenses. A P&L with all the owner's salary added back is referred to as Seller Discretionary Earnings (SDE), not EBITDA. SDE multiples are lower than EBITDA multiples.
Other adjustments are much more subjective. For example, you could conceivably add back a write-down or write-off of inventory. But this should be for a one-time event, not for write-downs associated with normal returns, defects, damage, etc. that you would expect to incur on an ongoing basis.
Any adjustments to EBITDA should be carefully documented in your communications with buyers, and expect the buyer and their bank to scrutinize and ask for documentation on each addback.
As always, there is much more we could add here! But we hope this is some initial food for thought, and please feel free to reach out with any questions or comments.
Hughes Klaiber is an experienced investment banking firm. Want to learn more about selling a business? Schedule a complimentary and confidential 30-minute phone call to discuss your business here. Or sign up to receive our blog posts delivered to you via email. SIGN UP
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