There are a lot of factors that go into what a company will sell for. We outline below some of the criteria that can affect the valuation of a company.
The financial health of your company will certainly be a major factor in potential buyers’ decisions on what they will pay for a company.
There are a lot of terms for income such as Cash Flow, Net Income, EBITDA and many more terms. First, we’ll discuss Annual Cash Flow. This is essentially what the owner makes from the business including their salary, perks, benefits, and net income. There may also be additions to this such as one-time expenses. For example, if there was a flood and the business had to be cleaned up, this expense would typically be added into Cash Flow as a one-time expense incurred that a new owner would not expect to incur.
EBITDA (Earnings before interest, taxes, depreciation, and amortization), is similar to cash flow but it subtracts what it would cost to pay a typical CEO in this industry to run the business. This may differ from the salary that the current owner makes. EBITDA is what the business would make for an investor after paying the normal salary to a president that would run the company for the investor.
The reason that Cash Flow and EBITDA are important is that what people are willing to pay is often based on a multiple of annual cash flow or EBITDA. These multiples can vary greatly depending on a number of factors. For example, if two company’s net incomes are both $500,000 one company might sell for 3 times annual cash flow ($1,500,000) and another might sell for 5 times annual cash flow ($2,500,000).
We will explore some of the factors that can affect what type of multiple a buyer will use to determine what they will offer for a business and what other factors other than Net Income buyers might use to determine the sale price of a business.
The industry that a company is in certainly plays a part in what multiples potential buyers are willing to pay for a business. For example a tech. company will typically sell for a higher multiple than a construction company. Even within technology a company that sells their own proprietary software will typically sell for more than a company that sell IT Services or acts a reseller of other companies’ technology.
Not to worry though. There are still a number of factors that go into what someone will pay. The industry is just one of them. A Profitable construction company might sell for a lot more than a software company depending on other factors.
Size of the Company
In general, the larger and more profitable a business is the higher the multiple of price to earnings is. For example, a company that has an annual net cash flow of $200,000 might sell for 2.5 times Cash flow ($500,000). Depending on the details, a company that has cash flow of $5 Million dollars might sell for 7 X Cash flow ($35 Million).
There are a lot more factors to this but this is an illustration of the amount of the earnings also factoring into the multiple that buyers will pay for a business. Valuing a business is part art and part science to combine all of the factors that go into a potential sale price of a Company. We’ll continue on with other factors that will go into it.
Synergies in a merger
Getting a buyer or buyers that have good synergies with an acquiring company can be a good way to increase value in the sale of a company and lead to a higher price paid. There are a lot of different ways in which you can have a synergistic buyer. We’ll outline synergistic possibilities from buyers in the same industry and buyers in different industries.
- Cost Reduction: A buyer within the same industry that is able to reduce costs by combining some of the overhead. Whether that overhead is the investment in underutilized equipment, space, or personnel. When underutilized assets are more fully utilized there can be an increase in the combined profits by reducing costs without reducing revenue.
- More Services to Cross Sell: More common than cost reduction is synergies that result in a profit increase through an increase in combined revenue. An example of this is where a civil engineering firm acquires a Land Surveyor firm and now they are able to cross-sell their existing customer base to provide more services to each other’s customers and increase the combined revenue. Also, they are able to win larger jobs where the bid involves both areas of expertise of the combined companies so that they don’t need to use subcontractors and can better control the quality and costs of the project.
- Taking Full Advantage of each other’s strengths: An example of this would be an acquisition of a small software company that has developed great new technology but doesn’t have a large sales force. This could be acquired by either an IT Services or Software company that has a large sales force and relationships with IT Departments at their customers but perhaps their products have become dated over time. The combination of these two firms would be able to more quickly sell the new technology and allow the more established firm a growth path that it wouldn’t have otherwise.
- Investor’s Contacts and Strategy: Synergistic mergers don’t necessarily need to be the combination of two companies. In some cases, you can have a wealthy entrepreneur or private equity firm that can acquire a company in an industry where they have contacts that they can use to introduce an acquired firm and get them into some large customers that they wouldn’t have access to. An experienced investor’s knowledge of an industry may also lead to invaluable advice on how a company should proceed to profitably grow their Company.
The trends in your business will affect the valuation of your company. For example is the revenue going up, down, or stable. They will also look at the trends in net income as well as the trends of the costs. On average they will pay a higher multiple for a company that is trending up compared to one that is trending down.
Also, the net income and revenue might vary a lot from year to year. In this case, some potential buyers might average the last three or four year’s net income to apply a multiple or they may use a weighted average where more weight is given to the most recent financial results.
Buyers will try to assess what a reasonable forecast is for a company in the coming years based on its trends and other factors such as what the overall trends of the industry are and external factors.
Another thing that positively affects value is having a number of different customers with no one customer making up more than 10 of your revenue. For example if two companies are both making a net income of $1 Million and company A has 150 customers with no one customer making up 10% of their revenue and company B has 10 customers with their top customer making up 40% of their revenue, typically company A will sell for more than company B.
Company B can still be sold however in some cases they will have to decide between a lower sale price and a higher sale price that includes an earn-out. An earn-out is a general term for a part of the sales price paid to be reliant on what the revenue and/or earnings are going forward. It is a way for the buyer to pay more and have the seller assume part of the risk if their largest customer doesn’t continue on with them. In many cases, the seller may stay on to make sure that the ownership transition is seamless and their large customers are retained.
If a company has recurring revenue this will typically make it more valuable. Recurring Revenue can occur in many different industries. An example would be two Landscaping companies.
Company A mostly does new construction landscaping. When new developments are being built they do the landscaping for these developments. Company B has long-term customers that they have ongoing relationships with and bill them every month.
If their customer retention is high and both Company A and Company B make the same amount of net income, typically company B will sell for more because they have recurring revenue with long-term customers that they have retained. This reduces the risk in a buyer’s mind that the revenue will decline.
Employee Skills and Responsibilities
Potential Buyers will consider the skills and responsibilities of the employees when determining the value of the company. If the business is based around the owner’s skills and the owner has all of the relationships with the customers this will be a larger risk factor when the owner moves on and typically the owner will need to stay on for a longer transition period.
A plus is if there is a management structure under the owner where employees report to the departmental managers as opposed to everyone reporting to the owner. If there are salespeople that handle customer relations and other important roles in the company, this is also a plus.
If the company is well thought of in the industry this, of course, is a plus. A minus would be if there is a pending lawsuit against the company from customers or employees. It doesn’t mean that the company can’t be sold but it may mean that the company will sell for a lower valuation. If the online reviews of the company are good this will also be a plus and put buyers more at ease.
Contracts and Agreements
Favorable long-term contracts with customers and employees is a plus. The length of the lease will also be a factor. If there is a short lease if a new buyer can get a long-term favorable lease this would also mitigate the short lease if the location is important to the business.
Also, they will look at any contracts with suppliers that may be favorable or unfavorable as the term of the contract progresses. Having exclusive supplier contracts is good. Another important item would if the contracts are transferable with or without consent. In some cases, the buyer may have to buy the corporate stock to ensure the transferability of the contracts.
If the financial information and other information on the business is clearly laid out and easy to understand this is helpful. It is useful to clearly identify what the owner’s salary, perks, and benefits are so the buyers can get a true understanding of what the owner is making.
Also in discussion with the buyer, it helps to be open and honest about the business to give potential buyers an understanding of not only the opportunities but any challenges they might face. This builds trust. No business is perfect so it’s best, to be honest in answering any questions. In addition, any challenges your business faces may be growth opportunities for a new owner.
There is no accounting for the chemistry between buyer and seller until they meet and get to know one another. A Seller that is easy to get along with and work with, makes it easier for potential buyers to pay a premium price for a business. It helps to be open to different styles and personality types during a sales process. At the end of it though, a seller has to be comfortable with a buyer as well.
Hire an Experienced Business Broker/M&A firm
A good Business Broker/M&A firm can help you to increase the multiple and sale price of your Company. They will have a large pool of potential buyers and will aggressively market the business while maintaining your confidentiality. Having a large number of potential buyers competing for your company will extract the highest price. An experienced broker will know how to position a sale to attract the most interest.
Synergy Business Brokers is a Leading M&A firm that specializes in selling companies with annual net incomes of $200,000 to $5 Million in industries such as technology, healthcare, manufacturing, distribution, services, construction, and education. We offer a free confidential consultation where we will learn more about your business and will provide you with an estimate of value at no cost. In fact, there is no fee until you Company is sold.