Thoughts on Quality, Risk and Value
By Brian E. Christian, Partner
The value of anything is pretty simple to define. Naturally, it is what someone else, at an arm’s length, is willing to pay for it…
When it comes to the value of a middle market, privately held business, this definition is arrived at by way of the product of two critical inputs:
- The past earning power of the business as measured by the adjusted earnings before interest, taxes, depreciation and amortization (EBITDA).
- The “multiple” applied to earnings.
One of the more frequent questions we, as B2B CFO® Partners, receive from our clients and prospective clients, generally takes the following form:
“If the value of my business is determined by multiplying my adjusted EBITDA by some “multiple”…isn’t this pretty straight forward without a lot of wiggle room?”
Given enough planning and foresight, both your adjusted EBITDA and the “multiple” can and should be managed prior to a sale. In fact, there is also an inter-relationship between the two where, if the adjusted EBITDA is properly managed, it can positively influence the “multiple” applied to it.
Managing EBITDA is more than just improving profitability, although improving profitability is almost always a key component because a seller will always want to show and pattern of increasing adjusted EBITDA in the years preceding a sale. The quality of your company’s adjusted EBITDA has a tremendous amount to do with influencing the value of your business. In almost every situation you can come up with, isn’t something of high quality going to be priced higher than something of lower quality? Of course the answer is “yes”…after all, assuming one could afford either one…why is a Rolex watch (even without a lot of diamonds) more expensive than the most advanced, highest priced Timex? It stands to reason that the higher the quality of your company’s earnings, the more someone will pay for it. In assessing the quality of your company’s earnings, various characteristics come into play depending on the nature of your business:
- How much revenue is derived from long term contracts?
- How much of your revenue is derived from one-off individual sales vs. re-occurring, contractual revenue?
- Are there customers that make up a significant concentration of the annual revenue?
Managing the “multiple” requires an understanding of risk to the purchaser. The relationship of “multiple” and ultimately, the derived company value, is inverse to the perceived risk to be borne by the purchaser. The greater the perceived risk to be borne by the purchaser, the less they will be willing to pay for the business by way of a lower “multiple” to be applied to its earnings. In assessing the risk associated with the purchase, a buyer may look at the following:
- The quality of the earnings and likelihood that they will continue or increase in the years following a purchase.
- The intellectual property associated with the company…how long have trademarks, service marks and patents left to run?
- Have the intellectual property items owned by the company been adequately defended since the company has owned them?
- Are they being violated in the marketplace (or the intended marketplace of the buyer) currently?
- Are there environmental risks associated with the company’s operations? Or the real estate that is owned or occupied by it?
- What is the status of the company’s accounts receivable and/or payable? Is there a likelihood of any related litigation?
For more information regarding all of the topical information that can influence the ultimate value of your middle market, privately held company, I strongly recommend that you obtain a copy of “The Exit Strategy Handbook” written and published by B2B CFO®. Copies are available by contacting the B2B CFO® partner nearest you, or please reach out to me directly via email at: firstname.lastname@example.org