Frequently, owners of small businesses obsess about the multiple their company will fetch when sold. While the multiple is important – a business sold at 9 times EBITDA is worth 50 percent more than if sold at 6 times multiple – that focus can be misguided.
That’s because the multiple of EBITDA, defined as earnings before interest, taxes and deprecation, at which the business is sold is, quite frankly, out of their direct control. The market determines the multiple through the sale process orchestrated by the seller’s investment bank or financial advisor that ideally involves several potential buyers.
What is under the business owner’s control is EBITDA and the steps taken to maximize it. By enhancing EBITDA, sellers are helping maximize the gain they will derive.
EBITDA, not net income, is the key metric for valuing private businesses
First, some background. EBITDA, not net income, is the key metric for valuing private businesses. Looking at businesses without the impact of “ITDA” – interest payments, a function of the business’ debt; taxes, which vary based on the jurisdictions where the business is based and generates revenue; depreciation, which tends to be more for manufacturers, less for those with few physical assets; and amortization, typically larger for companies that have completed serial acquisitions – helps normalize value across disparate industries and capital structures.
Try this if thinking of the sale of a business: Put yourself in a buyer’s shoes and consider these steps that will impact EBITDA directly and yield a business with higher-quality financial returns:
· Reduce the personal expenses that run through the income statement. It pays to wean the business away from financing home repairs or keeping your kids on the P&L. If you don’t, your buyer will.
· Get audited financials. Audits for small businesses are not expensive. You will realize multiples of the $10,000 or so you spend from the buyer’s lessened interest.
· Discuss bonus compensation in advance. Small businesses often use large post-EBITDA bonuses to reward key executives and return capital to family members. If future management compensation and family payments won’t flow through the income statement, discuss them before the sale.
· Eliminate perks. Middle market owners can be attached to the boats, cars, private planes and country club memberships their business finances. But recognize that once these benefits are marked-up at the buyer’s multiple, they will have a disproportionate negative impact on the business’ perceived value.
· Document nonrecurring expenses. Things happen in the life of every small business so document mishaps, fall-offs and higher discretionary expenses to ensure the business gets credit for EBITDA that will prove more robust than otherwise.
These suggestions are true no matter what type of sale you are considering- ESOP, M&A or IPO.
Consider our advice to the owner of several related businesses constituted as separate corporations with different names and distinct financial statements. The owner retained us to sell the combined entity, but historical financial information did not exist for it. Consequently, he had three strikes against him. Unified financial statements would be lot of work for a buyer to create. The separate businesses bred suspicion as to the integrity of the whole. And each entity had distinct add-backs, such as personal expenses and excess compensation.
We recommended he invest in a “Quality of Earnings” report prepared by a reputable firm, which enabled him to present potential buyers with clean, coherent and well-vetted financial statements depicting the business as the attractive investment opportunity it truly was. The owner realized a successful exit with exponential payback on the cost of the report on quality of earnings.
A powerful benefit emerges by taking steps to maximize EBITDA before beginning the sale process. It’s the psychological lift those actions provide the buyer. Just as landscaping and mowing your yard conveys tidiness and maintenance that positively inclines a prospective buyer to pay your asking price, a prospective buyer will be more interested in acquiring your business if his or her “quality of earnings” due diligence report unearths few red flags.
In truth, these proactive steps are the one factor impacting your business’ multiple that is under your control. So, improve your business’ “curb appeal” before beginning the sales process. You will capitalize on its high-quality EBITDA and present your business in its most attractive light – and that will maximize its multiple.
