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The crux of multiples in business valuation

March 2, 2018

By Martha Sullivan, CPA, CVA/ABV, CM&AA, CEPA
Partner, Succession Planning Practice Leader

Martha leads HK’s succession and exit planning services division and is a regular contributor to Wisconsin’s InBusiness digital magazine.

Multiples are always a hot topic when you gather groups of business owners, investment bankers, and/or other advisors. Folks want to know what’s going on in the market for buying and selling companies. Are the multiples going up or down? What multiple is that industry seeing?

Business owners often focus on “What did that guy get?” as a multiple. This frequently leads to “Well, if he got that, I must be worth this! (“This” always being a higher number than the other guy.)

On the surface, multiples appear to be straightforward. You take a measurement that’s a good proxy for cash flow — such as earnings before interest, taxes, depreciation, and amortization (EBITDA) — times the multiple and voila, you have the value of the business! Sounds pretty darn simple.

Bear traps are pretty darn simple, too. It’s best to know how a bear trap works, though, so you can navigate it and avoid getting caught on the wrong side of it.

Unlike bear traps that don’t care which bear it snared, multiples are very specific to the individual company. The offered multiple is fundamentally a measure of the specific investor’s perception of the risk that he or she is willing to take on for what he or she is investing in. The lower the perceived risk, the higher the multiple. Similarly, the lower the risk and higher perceived potential, the higher the multiple. (The buyer’s situation plays a key role in the multiple, which will be the topic of my next blog.)

Perceptions of risk are the reason one buyer could look at two seemingly identical companies with the same revenues and same bottom line and offer two incredibly different multiples. Consider these two fictitious companies in the same industry. Assume they have identical financial statements and EBITDA, but differ in the following ways:

Awesome Sauce Inc. Bitter Applesauce LLC
  • Fully operational and experienced management team with distributed decision making.
  • Diverse customer base.
  • Documented, state-of-the-art systems and processes with cross-trained employees.
  • Recipes, trademarks, patents, etc. legally protected.
  • Daily dashboards. Monthly financial statements issued by third business day. Clean annual audit.
  • All decisions made by or approved by owner.
  • 60% of revenue comes from single customer.
  • Systems are antiquated. Process knowledge in heads of owner and employees. No documentation.
  • No legal protection over intellectual property.
  • Financial reporting backlogged three months, with poor quality and accuracy.

It’s clear which company presents greater risk to the buyer. These factors scratch the surface of the value drivers and risks considered when a person is thinking about investing in or buying a company. The multiples that would be bid for these two companies would be substantially different, which has an even greater impact on the value of the business. For example, if EBITDA is $2 million and the two multiples are 5 versus 3 respectively, that’s $4 million more in the pocket of Awesome Sauce’s owner than Bitter Applesauce’s. The buyer isn’t being mean or cheap. He or she is being realistic about the risk and reward equation of their investment.

Of course, you can bet Mr. Applesauce is going to be disappointed, extremely confused, and, well, bitter. All he sees is that he is getting less. He doesn’t understand (or want to acknowledge) why he is getting less. He’s not stepping into the shoes of the buyer and forcing himself to be objective about his company.

Mr. Applesauce is not alone. Many owners in the heat of the daily battle of chasing sales, getting orders out the door, and the bills paid, lose sight that the awesome sauce in their business depends on objectively identifying, mitigating, and managing risk in the company. Then the company has the infrastructure and ability to grow, thrive, and survive, regardless of who owns the business.

The crux of multiples, like many things, comes down to “it depends.” There is always more than what meets the eye. My challenge to you is to make sure your company is the one with the awesome sauce.

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