I’m often asked the tough question: “What do you think this business is worth?”
I’m going out on a limb here, because while I am a CA and spent four years in the valuations practice of PwC, I am not a qualified chartered business valuator. However, having financed many mergers, acquisitions and buyouts, I have a perspective to offer here.
I will limit my comments to what I know most about: mature, small and medium-sized businesses that have revenues ranging from $5 million to $50 million. No startups, no large companies, no resource industries – just solid private companies that make up the vast majority of businesses in Western Canada.
Identifying valuation parameters across so many industries starts with recognizing a fundamental truth about worth: the value of anything depends on its demand and supply in a market. Everything else is just theory. If you have more buyers with capacity than sellers with businesses, the price paid will be higher. Timing the cycle therefore is as important as the underlying attributes of the business.
The market cycle is influenced by demographics, the availability of capital and economic growth. As a prospective seller, ideally you want to time all three perfectly: when your business is generating the most cash flow in a strong economy, capital is readily available and cheap, and there are many qualified buyers.
I would rate the current environment as 7.5 out of 10 in favour of sellers. While the economy is growing only modestly, there is lots of capital available to a long list of buyers. I believe there will be improved balance in the next few years as more business owners want to retire.
Demand is greatest for quality businesses, but not as much for anything inferior. Between businesses, what buyers get most excited about are consistent and growing earnings or, more specifically, cash flow. They are willing to pay a higher multiple of earnings for high quality cash flow, arising from:
•revenue that is consistent, recurring or contracted for long periods;
•strong competitive advantages that can be defended against competition and knock-offs;
•high gross margins resulting from valuable brands or proprietary products and services;
•low requirements for capital expenditures, so the profits can be taken out rather than having to be reinvested; and
•profitability that’s independent of the seller’s involvement.
Buyers care about the past, but only as an indicator of the future. They have to believe the business can grow or at least sustain its current earnings. The most highly valued businesses demonstrate a history of growth that has reasonable prospects of continuing. Even better is a growing business that offers a great brand or technology that can be introduced into other markets.
For high quality businesses, I see valuations above five times normalized historic EBITDA, sometimes stretching up to six or seven times. For lesser quality but still positive cash-flow businesses, the valuation range tends to be lower at three to four times EBITDA. The midpoint is around four to five times. This assumes the purchase price includes assets required to operate the business, such as normal working capital and capital assets.
Meanwhile, a corporate acquirer can justify paying for synergies as long as the buyer still gets a good deal.
Put another way, without the seller’s business, the potential synergies don’t exist. However, it’s been my experience that all potential synergies, including revenue opportunities and cost savings, are rarely achieved.
To crosscheck the value of a business, think in terms of return on investment. Because there are many alternative investments available, the buyer needs to achieve a minimum return on investment (ROI). Small private companies are risky and demand a very high ROI. If a buyer can comfortably leverage some of the purchase, then the ROI will increase. The availability of debt comes back to the quality and consistency of aforementioned cash flows. If you add up all the cash flow, deduct payments to lenders and see that residual cash flow is returning less than 20% to 25% ROI, the valuation is too high.
Obviously, there is a lot more that can be said about the valuation of businesses, and every business needs to be considered on its merits. If you are considering buying or selling a business, you should work with a qualified valuator or business intermediary to guide you through the process and get you the best deal. •
