Last month we discussed understanding the realistic value of your business. The current state of the financial markets is a big factor, but beauty is also in the eye of the beholder. Different buyers value acquisitions in different ways. Knowing the type of buyer that your company will attract is an important element in estimating its value.
There are three major classes of buyers: entrepreneurs, professional (or financial) buyers, and strategic acquirers. Each class seeks different opportunities, and pays based on different metrics.
Entrepreneurs, or “Main Street” buyers, are typically seeking a business they can run personally. They might be former corporate executives, local competitors, or anyone venturing into self-employment for the first time. They typically seek companies priced at less than $3,000,000, or those most often represented by business brokers.
Because these buyers are also operators, valuation is usually based on Seller’s Discretionary Earnings (SDE). This includes all the benefits that accrue to an owner, including insurance, a company vehicle, retirement contributions, salary and profits. Since these buyers are most often using a third-party loan for the purchase, “lendable” values top out at between 2.5 and 3 times SDE.
In the middle market, companies valued between $3,000,000 and around $50,000,000, Private Equity Groups are most active. These are professional buyers, using investors’ money to purchase based on anticipated financial returns. They seek businesses with at least $1,000,000 in EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Because they will use employees (or minority shareholders) to run the company, they don’t place much value on an owner’s personal benefits.
Private Equity Groups purchase using return on investment formulae, so pay values in a relatively tight range of between 4.5 and 5.5 times EBITDA. Acquisitions over $10 million are higher, and values in this “loose” (low interest) financial environment have been strong.
At the top of the food chain, we find the strategic buyers. They are larger organizations, frequently publicly traded, who buy smaller businesses because it is less expensive than creating a product or service from scratch. To attract these buyers you must have true differentiation from your competitors.
Because these buyers are themselves valued at public company multiples, they are able to justify far higher purchase prices. Few small businesses, however, have sufficient uniqueness to justify their attention.
What we have left represents a substantial percentage of the 3 million Baby Boomer owned companies. These are usually between $5,000,000 and $15,000,000 in revenue. They are nicely profitable, but don’t reach the threshold of $1,000,000 in pre-tax profit after owner compensation.
These companies are in the “neutral zone”— too big for entrepreneurial buyers, but too small to attract professionals or strategic acquirers. It often comes as a shock to owners who spent decades building an excellent business that there is no one who is interested (or capable) of purchasing it.
Often the answer for these owners is a sale to employees, either via a Leveraged Buy Out (LBO) or an Employee Stock Ownership Plan (ESOP.) Planned and executed correctly, either method can lead to a sale where the owner realizes full value for the business, and maintains control of the company until the proceeds are safely in his or her pocket.
Next month we’ll discuss how to sell a business to its employees. In the meantime, take a look at this short video to help you understand valuation a little better.