I recently met with a business owner who had contacted me to discuss the prospect of selling his business. The owner was not quite ready to retire and loves his business but was doing his due diligence and future preparation for succession. I congratulated him on building something that has given him both pleasure and financial well-being. But at the same time I felt obligated to point out a simple truth that he should at least consider. The truth is that there is at least a significant possibility that the amount of money he could sell all or part of his business for today may be the business’s peak value from his prospective. I was not proclaiming that is the case, but the possibility must be factored into his risk equation.
With regards to the example business above, here are three (of many) factors to consider:
1) At this point in the investment cycle for middle-market businesses EBITDA multiples are historically high, perhaps the highest in history. There are several reasons why this may be, including low interest rates, an expanding economy, and competition for such business enterprises amongst financial buyers.
2) Growth…The economy is growing and that makes it easier for an individual business to grow along with it. It is like the saying, “A high tide lifts all ships”. The growth prospects of a business are the single most important factor affecting valuation.
3) At this point in time the business is healthy, meaning there are no overhangs such as litigation, accounting issues, or other systemic issues on the horizon. Both strategic and financial buyers covet businesses that are clean and growing.
Example and explanation…
To my point above, let’s take an example of how significant a sale today could differ from a sale in one year from now. Arbitrarily, let’s say that a business is going to do $5M in EBITDA this year and let’s assume the business is healthy and has a growth rate of 15% per year at this point in time. Because of the growth prospects of the company, an investment group such as a Private Equity Fund may be willing to pay an EBITDA multiple of say 12 times. So 12x$5M = $60M valuation or purchase price. Now let’s say a year passes and the economy begins to slow. Because of the slowing of the economy, the business itself may have a slowdown in sales or margins. Now let’s assume the business will do $3.75M in EBITDA and the growth rate has slowed to 5% long-term. The same Private Equity group may now be willing to pay 6 times EBITDA. Therefore, the new valuation is 6x$3.75M for a total of a $22.5M valuation or selling price.
As you can see, the valuation of the example company delineated above plummeted from $60M to $22.5M in just 1 year and yet the business only did $1.25M less in EBITDA. Many business owners do not realize how much small differences in growth rates can have an exponential influence upon the value of an asset (in this case their business). The growth rate, or the potential growth rate that is perceived by the buyer, makes all the difference in the world as far as valuation and enterprise value are concerned. The valuation of a business is simply the sum of all of its future cash flows, discounted back to the present day. When growth slows, all future cash flows decline dramatically. Accordingly, changes in the macro economy or more specific changes to the business sector or company itself can have an enormous impact on both growth and valuation. This is why you must at least consider striking while the iron is hot.
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