Throughout the sale process, we will make every effort to be transparent, even when it comes to how we will value the business. Anecdotal evidence suggests that a great number of deals fall apart at the valuation stage. Providing a look-in on how we value will not ensure that we will agree on a valuation but at least the seller will understand how the number was determined.
Building Trust Through Transparency
We will most likely value the business using different methodologies. These include:
When it comes to a final offer, the dollar value will be expressed as a multiple of EBITDA. Companies in the size range we target typically trade for 3x-5x EBITDA. To arrive at a final valuation, we consider the following factors.
Companies in different industries trade for different multiples. Currently, companies in technology and healthcare are trading for higher multiples than industrial companies.
In the lower middle-market, some consider the breakpoints to be (expressed in EBITDA):
- • $500,000
- • $2 million
- • $5 million
Companies in the $500,000-$2 million range will sell for lower multiples than those with EBITDA above $2 million.
Historical and Projected Growth
High growth companies are rewarded with higher multiples. The baseline assumption for growth is 3%.
Not only does total profit matter, profit as a percentage of revenue is important as well. Companies that earn more for each dollar of revenue are valued more highly. EBITDA margins of at least 10% are the norm for many industries.
The assumption for most businesses is that revenue is spread among several different customers. If one customer represents a disproportionate share of revenue, this will lead to a reduction of multiples. Typically, if any one customer’s share of revenue is greater than 20% then it will raise an eyebrow, but not necessarily reduce the multiple. This also applies to customers in similar industries. If a large percentage of customers are in one specific industry, that will be cause for further investigation.
Strength of the Management Team
We have mentioned before that we place a high value on people and attitudes. Strong management teams typically lead to strong companies. Additionally, with a strong management team in place, we will be able to spend our time pounding the pavement trying to increase revenue. One difficulty, though, is that determining how the strength of the management team will affect the multiple is much more subjective than other factors.
There are a variety of other factors that will be considered but those are among the most important. Valuing a business is often more art than science. We can try to make it objective but ultimately a judgment call must be made.
What is SDE? What is included in the Sale Price?
In the lower middle-market, sometimes the term SDE, or Seller Discretionary Earnings, is used in place of EBITDA. The concept is that SDE encompasses the amount of cash the Seller gets to decide how to spend. This often represents a cash flow with no owner compensation and/or no rent or mortgage. We also see deals where inventory is not included in the purchase price.
Different people and firms think differently as to what is included in the purchase price. When Four Pillars Investors makes an offer, that offer is for a specified level of cash flow. If the owner truly is absentee and no replacement is needed, then we will add back his/her compensation to EBITDA. Considering we focus on manufacturing companies, we have rarely found a situation where no rent or mortgage was required so that would not be an added back.
In regards to inventory, the starting point is that inventory is included in the purchase price. Again, we are purchasing a cash flow and if the seller determined that inventory was required to produce a certain level of cash flow, then we will include it. Determining how much total working capital is included is not as straightforward. In short, it will be based on historical levels.
How Will the Deal be Financed?
A typical investment is funded by equity, senior debt, and a seller note. Our equity is comprised of personal funds of those at Four Pillars and capital from a small group of successful entrepreneurs and executives. Though we could fully fund the equity portion from outside investors, we want to be personally invested in the business.
A seller note is a form of debt that is issued by the seller to the buyer of the business. Seller notes are often subordinated to other debt issued to complete the sale. An owner that is willing to carry a note is very important to us because it aligns incentives. We are not looking for an owner that wants to exit immediately. That can suggest that the owner does not have an interest in the long-term success of the business. We desire partnering with an owner and management team to ensure a smooth transition, increase the likelihood of achieving our growth targets, and, most importantly, provide job security for all employees.