For many small business owners, selling a business represents the culmination of their entrepreneurial career. You have built your business from the ground up and now it’s time to slow down and enjoy the fruits of your labor. You are ready to make the transition from understudy to lead role and play the part of Rod Tidwell in Jerry Maguire. You want somebody to “show you the money” (click here for scene from the movie) and rightfully so having built a successful business over the years. Ironically, your final task – selling the business – can also be the most stressful. People make the process of business valuation too complex. It is really much simpler than most realize. The best way to think about the value of your business is to understand how a buyer will look at it. A seller must remember a business is only worth what someone is willing to pay for it. Simple idea, right? Wrong! It never ceases to amaze me how convoluted an entrepreneur’s thinking is about the value of their business. Just as it is critical to think like your customer to be successful in growing a business, an entrepreneur must learn to think like a buyer when the time comes to exit the business through an outright sale or a leveraged recapitalization. (For additional information on a leveraged recapitalization please see my previous blog post “Pocket Full of Chips and Still Playing“) Here is a concise synopsis of a few factors MCM Capital Partners, a leading Cleveland based small cap private equity fund, considers when valuing a business.
The values of private companies are expressed as a multiple of EBITDA (earnings before interest taxes depreciation and amortization). Several variables, both internal and external, effect the multiple and thus the fair value of a private company. Although this blog will discuss each of these individually, these factors are inter-related and must be taken as a whole in assessing value.
Internal factors are those indigenous to the company that shareholders and management have the most control over. These include: strength and breadth of the management team, financial track record, competitive advantages, and a diversified customer base.
- Strength and Breadth of Management Team. As investors and board members MCM believes we add value to our portfolio companies, but ultimately the success or failure of any investment is dependant on the skill of the management team. Thus, MCM’s investment analysis always starts with an assessment of the CEO and overall strength of the management team. Although the CEO is the key driver in any business, our evaluation includes an assessment of executives in the key functional areas of sales, engineering, operations and finance. The stronger and deeper the management team, the more inclined we will be to assign a premium valuation to the Company.
- Financial Track Record. This rather broad variable covers several areas of specific interest including the company’s historical levels of profitability, sales and earnings growth, and cash flow from operations. MCM uses these historical financial measures to assess the current management team’s capability and as an indicator of expected future financial performance. A private company with a strong record of profitability and growth will command a higher multiple of operating earnings than an average performer.
- Competitive Advantages. A company’s competitive advantages will be considered in the process of determining value. These competitive advantages can take many forms including, but not limited to, superior brand recognition, proprietary products or processes, best in class customer service, broad product lines, unusually strong distribution, and extremely efficient operations.
- Diversified Customer Base. Companies with higher levels of customer concentration will tend to command lower multiples for the simple fact the business is more likely to be materially affected by the loss of a prominent customer.
External factors also play a role in determining fair value. Those we deem most relevant include the growth and cyclicality of the target’s industry and the existing supply of acquisition capital.
- Growth and Cyclicality of Industry. Companies, which compete in growing, less cyclical markets will command a higher multiple than a company which operates in a mature cyclical industry. This is particularly true if the market perceives the industry cycle is at or near its peak.
- Supply of Equity & Debt Capital. The private equity markets are subject to the laws of supply and demand. Thus, the supply of capital, relative to the supply of potential transactions, will impact company valuations. Preqin, a London-based research house notes the global private equity industry’s dry powder (i.e., uncommitted assets) continues to exceed $1 trillion, suggesting that there is still plenty of capital waiting for a rainy day.
If you would like to review the most up-to-date data on purchase price multiples and leverage multiples or would like more information on our small cap private equity firm and investment principles, contact us today. We would be happy to share with you valuation data available from independent third party sources.