What Are Buyers Paying for Main Street Businesses?
This article originally appeared in Forbes.
As of early 2014, about 27 million businesses exist in the U.S. Of those, only 300,000 earn more than $5 million in annual revenue, and only 150,000 earn more than $10 million.
“Main Street” businesses are the large group bridging the gap between small business and the corporate world — earning roughly $2 million to $30 million in revenue and resulting in between $500,000 and $5 million in earnings before interest, taxes, depreciation, and amortization. With such a wide range of numbers, it’s crucial to understand your market position as you prepare to sell your Main Street business.
Calculate Your Multiples
The valuation of any asset is an attempt to estimate the present value and the likelihood of future cash flows and compare it to other opportunities. The most common result for operating businesses is a multiple of EBITDA. For example, if a business has EBITDA of $1 million and the multiple is 3.5, then the valuation would be $3.5 million.
According to the Pepperdine Private Capital Markets Project, depending on a company’s size, multiples of Main Street-sized transactions have averaged between 2.6X and 4.5X. The example valuation described above reflects the average multiple (3.5X) for EBITDA of $1 million.
While averages can be helpful in framing a discussion, the involved parties are the real determinants of an asset’s worth. So what are the most common factors that lead to increased or decreased valuations?
1. Owner involvement: Everyone loves to feel needed, but for an owner trying to sell his business, this is a major challenge. The more vital the owner is to the business, the more challenging it will be to replace him. Replacement costs for owners involved in day-to-day operations typically fall between $125,000 and $400,000 and are deducted from the estimated EBITDA.
2. Client concentration: The more power any outside force has over the performance of the business, the riskier it is. For instance, if a client represents more than 20 percent of revenue, multiples typically start to drop.
3. Necessary capital expenditure: A business that throws off a lot of cash but requires almost all of the free cash flow to be reinvested in the business isn’t worth much. Rather, a good indicator of the necessary capital expenditure is depreciation, which allows for the assets of the business to be deducted from profits during the course of the asset’s lifetime. Although EBITDA is a commonly used metric, it’s usually only useful when CAPEX is low. The more cash that’s needed for reinvestment, the lower the multiple.
4. Processes: Some successful businesses are run off “feel” by an experienced operator who is substituting her intuition for repeatable processes. The ability to replace such a person is next to impossible. The less a business is process-driven, the lower the multiple.
5. Redundancy: What if a bus hits a key person? The more dependent a business is on a few key individuals with little to no redundancy, the lower the multiple. Any buyer will look at that situation and consider two options: Do nothing (and have elevated risk), or create redundancy (and decrease profits).
6. Consistency: Some businesses have revenue that comes in like clockwork at the same sustainable margin. Other businesses frequently go through fits of feast and famine. Ultimately, all that matters is the performance of the business during a normalized period of time (taking cycles into account), but most buyers prefer consistency.
7. Regulation: Regulation is a double-edged sword. It creates barriers to entry, which increases the value of any existing business, but it also carries significant risk for increasingly arduous requirements that can negatively impact profits (think Dodd-Frank for banking).
Set Realistic Expectations
In the Harvard Business School report, “The Market for Smaller Firms,” Richard Ruback and Royce Yudkoff noted that Main Street multiples are half to a third as large as those for comparable larger companies. The variance in comparison to larger firms is due to several factors, including:
Search costs: While sale prices are much lower, the search costs for lower middle-market businesses are comparable to (or larger than) those of bigger acquisitions due to difficulty in finding viable sellers in the marketplace and complications in financial reporting that must be sorted out prior to a sale. The search costs can represent up to 20 percent of the acquisition cost, which reduces the amount a buyer is willing to pay.
Number of opportunities: Today, most Main Street businesses are owned by baby boomers.As the president of Cornerstone Business Services Scott Bushkie says, “It’s unlikely values will increase as long as there’s a larger number of baby boomers selling than there are buyers looking for Main Street opportunities.”
Size and risk: Main Street businesses lack the benefits of scale that sophisticated buyers of larger businesses are familiar with.“A larger firm, say one worth $10 billion, is not simply a collection of one thousand $10 million firms,” said Ruback and Yudkoff. “Instead, in larger firms, there are bigger product lines, similarities across product lines, and systems to make the $10 billion business much easier to understand.”
Apply Your Multiples
Understanding multiples prior to marketing your business puts you in a better position to negotiate. Buyers appreciate when sellers can articulate why they believe a business is worth a particular price. For example, if you think your Main Street business is worth 5X, you must recognize that you’re positioning your business on the higher end. Be prepared to explain why you believe it’s worth that much.
However, negotiation isn’t simply about multiples. As you set expectations, look at where buyers start — the EBITDA. Analyze your financials, and figure out what factors may cause adjusted EBITDA to be driven down in the course of both initial negotiations and due diligence. A high multiple may sound good, but if the EBITDA is low, it won’t matter.
Think through how you’d like the deal structured from a financial standpoint, as well as your timeline and your preferred level of involvement post-sale. If you can explain these factors to a prospective buyer early on, you’ll save everyone involved a substantial amount of time and set up a constructive environment for negotiation.
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