A Crash Course on Earnings Multiples
As a trusted business advisor I have heard former business owners telling people that they sold their business for “six times earnings.” As Business Intermediary, the first question we hear from prospective clients is “Can I get the same multiple if I sell my business?” The answer is an unequivocal "it depends." It depends on a number of things, but first and foremost, it depends on how you define “earnings”.As all business intermediaries and sellers know, “Cash is King.” After all, cash removes the seller’s risk in the transaction. However, when a buyer pays cash for a business, that buyer wants to know exactly how much the business is earning.
Let’s start with what seems to be a pretty basic concept: earnings.
There are several definitions of earnings; each is potentially different from the other depending on the type of company and the way its owner runs the company. Typical measures of earnings include:
Net Operating Income: This is sales less the cost of goods sold and operating expenses.
Pre-tax Income: This is net operating income plus non-operating income (like interest on notes, etc.) less non-operating expenses (like one-time, non-recurring expenses).
After-tax Income: Pre-tax income, less all company (but not individual) taxes.
EBIT: This stands for earnings before interest and taxes.
EBITDA: This stands for earnings before interest, taxes, depreciation and amortization
Add to these measures, the need to “adjust" earnings by deducting capital expenditures, and adding back excess rents, excessive salary and bonuses paid to the owner and his or her family.
This results in something called:
Owner’s Discretionary Cash Flow or True Cash Flow: This is the amount of pre-tax money distributed to owners via salary, bonus, distributions from the company such as S-distributions, and rental payments in excess of fair market rental value of the equipment or building used in the business. This provides buyers with the most accurate indicator of how much “cash” a company can actually produce and is often the most meaningful indicator of value.
Which brings us back to our original question: Is it realistic for a business owner to expect a six times multiple when he sells his business? There is no one right or wrong answer to this question.
To show you how tricky this can be, let’s look at a former client of ours. His business was not doing well. He had revenues of approximately $7 million but, even using the most generous definition of earnings, the company was not earning more that about $100,000 per year. We ultimately sold the company to a buyer of distressed companies who paid book value for its assets or about $2 million. Despite this low value, our client was extremely happy because his business sold for 20 times earnings! In this case the buyer was buying assets, not earnings, so an earning multiple wasn’t even appropriate.
To determine which measure of earnings is appropriate for a business, you need to look first at how the seller’s industry defines “earnings”. This "earnings" measure reflects how much a buyer can afford to pay for the business. The actual multiple applied will be based on:
à what is appropriate for a given industry,
à what the company’s specific growth prospects are,
à how the company’s earnings compare with similar companies in the same industry, and finally
à how the company’s earnings compare with the company’s asset value.
So after all of this you can see there are no easy answers.
2/6/2008 What To Expect From A Business Intermediary 2/6/2008
Anyone who is considering selling - or -buying a business wants to know the advantages of using the services of a business intermediary. They also want to know what to expect from using their services.
Let's look at this question from the seller side first. In most cases, the business intermediaries is listing the business for sale. In most cases the business intermediaries is representing the seller and is duty-bound to represent the seller honestly and fairly, A business intermediary is also charged with trying to get the highest possible price - and the best deal - for the seller. However, sellers must understand that, no matter how hard the business intermediary tries, it is the marketplace that ultimately determines the price and terms - not the business intermediary or the seller.
The business intermediary will keep the seller informed, on a regular basis, of the status of the listing and will do everything possible to maintain the confidentiality concerning the sale of the business. However, selling a business is a two-way street and requires cooperation on both sides - seller and business intermediary. The intermediary needs to be kept aware of current information regarding the business, such as sales trends, major equipment purchases, inventory fluctuations and the like. The business intermediary and the seller must work together; they are on the same side, and they should work as a team.
No one likes to waste their time, and business intermediaries can show buyers businesses that fit their pocketbook and still can provide the necessary income to provide for their families. Buyers want candor in the presentation of the business, The business intermediary is an expert in problem resolution - he or she can resolve issues and misunderstandings easily and quickly.
Professional business intermediaries bring value to the process of buying and selling businesses. They understand the issues and the details involved in the business transaction. They have the knowledge and experience to bring the sale to a successful close. If the buyer and seller are honest with the business intermediary - a win-win situation will result.
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