Small businesses (100 employees or less) have the lowest valuation multiples of any business.
A review of the HBR Guide to Buying a Small Business, an authoritative source, tells us what we need to know about small business valuation multiples.
This HBR Guide was written by two Harvard MBA professors for MBA students considering their future careers. The professors hope that students come to see buying a small business “as we do – as an attractive third path, an exciting alternative to big corporations and risky start-ups.”
The following 3 paragraphs are excerpted from chapter 14 of the HBR Guide, which is called: How Much Should You Pay for a Small Business?
“The purchase price of a small business is often expressed as a multiple of the most recent year’s EBITDA (earnings before interest, taxes, depreciation, and amortization). The kind of enduringly profitable small business that we’ve described in this book with EBITDA of between $ 750,000 and $ 2.0 million – tends to be priced between 3 and 5 times the EBITDA (often expressed as “3x– 5x”). This means that if the most recent year’s EBITDA is $1 million, the purchase price would range from $ 3.0 million to $ 5.0 million.
While not all smaller businesses sell in this range – distressed firms typically sell for less, and firms that appear to have enormous growth potential often sell for more – our experience and research indicate that this price range does apply to enduringly profitable, smaller firms in traditional industries with established business models and moderate growth prospects. Larger companies ($5 million or more in EBITDA) often cost much more – more like 6x-12x EBITDA.
You can buy high-quality small businesses for a price that allows you and your investors to earn an excellent return on your investment. Some of this return will be cash flows that you’ll distribute each year to your investors. Eventually, you and your investors might sell the business, and if you’ve been able to grow it, you should be able to sell it for far more than the purchase price, resulting in a meaningful financial gain. So, buying a small business offers both an exciting career and a significant investment opportunity.”
In their case study, the professors use a multiple of 4x EBITDA. They explain that a 4x multiple generates a 25% return on investment is 25%; and more with financing.
To put a 25% return – and more with financing – in perspective, consider that Warren Buffet has only averaged a 21% return since he purchased Berkshire Hathaway in 1962.
The professors also point out that most owners of enduringly profitable small businesses do not want to sell them but end up being forced to sell because of age or health-related issues. The professors point out that distressed sales produce a more favorable purchase price and a better return for investors.
The point is: students at the world’s best MBA school are told that enduringly profitable small businesses are the best investment opportunities they can find. Yet, owner-managers routinely put themselves into an impossible situation that inevitably fails because they need to find someone outside their firm who can buy their company and take over its management. However, an investor who can write a multi-million dollar check does not want an owner-manager’s job, this is why investors are willing to give MBA graduates 20% of the shares of the business plus a salary, to step-in and manage the business for them. The trust is that it is the owner-manager, themself, who has built an owner-dependent business with the lowest possible valuation.
There is an alternative. We call it “10x-ing value by finding freedom for all.” In this post, we focus on the formula for 10x-ing value. The essential idea is that you as the owner-manager, should do what investors do: professionalize the business and find a manager to run the business for you. First, we will talk briefly about freedom.
Freedom means different things for different people:
For the owner-manager, it means freedom from day-to-day responsibilities and a transition into an investor-advisor role.
For the managers, freedom means stepping up into a leadership role with real decision-making capacity, and an ownership stake in the business. The idea of an ownership stake for managers strikes many owner-managers as risky or unnecessary. The risk depends on the trust level of the relationship, and if the manager is running the business for the owner there must be a high degree of trust. It is common practice among successful investors to provide ownership stakes to their managers to align interests. The plan set out in the HBR Guide provides for the MBA graduates who will manage the business to receive 20% of the shares from the investors, for free as an incentive.
For the employees, freedom is meaningful work that is secure, pays well, and provides for retirement. It is becoming increasingly common to provide for general employee ownership as well. The mammoth private equity firm KKR now uses employee ownership plans as standard practice in all investments in its industrial portfolio. KKR has the data that proves that employee ownership plans increase both: employee engagement, and return on investment.
The formula for 10x-ing value
If we are going to 10x value, we have to know the starting valuation. In our formula, we will use the numbers from the HBR case study example of: $1 million EBITDA at a 4x multiple = $4 million as the starting valuation. Our goal is to provide a simple, conservative method for 10x-ing that $4 million valuation. The 10x-ing formula has four ingredients:
- Starting EBITDA
- EBITDA growth rate
- Compounding period
- Multiple at the end of the period
For each ingredient, we will pick a conservative number, and at the end, we will combine our ingredients to find the ending valuation.
1. Starting EBITDA
The first ingredient is the Starting EBITDA used in the HBR case study: $1,000,000.
2. EBITDA growth rate
When a business has been enduringly profitable for 20 years that means that it has a solid foundation that you can build business growth on. As soon as you increase the management capacity of an enduringly profitable business, put in lean systems, and engage the employees the revenue starts to squirt upwards. We call this popping the cork. This rush of growth happens when a competent management system is installed into an enduringly profitable owner-managed business.
For example, the most successful system for owner-managed businesses is the Entrepreneurial Operating System (EOS). EOS has more than 500 full-time implementers who are working with 10,000 owner-manager clients. The founder of EOS, Gino Wickman says, “On average, my clients’ businesses grow revenue by 18 percent per year.”
A growth rate of 18% is consistent with our experience at Intelligent Work, and remember, it is an average. We have seen clients do substantially better, and we have seen situations where it was too late to act.
There is a small detail to clear up. Gino uses the term “grow revenue.” We assume that a properly managed business will “grow EBITDA” more or less, at a similar rate as it grows revenue.
3. Compounding period
One year of EBITDA growth at 18% will not get us anywhere close to our goal of 1,000% growth in value (10x). We need more time. But time has a friend, the power of compounding. 18% compounded growth is a much different animal than 18% growth.
We have to set a realistic Compounding period. No one will accept 30 years. Setting a 10-year target is standard business practice. A 10-year target gives us sufficient time to develop all of our plans for the business thoroughly.
When the business depends on the owner to make all the decisions, the company will suffer and maybe collapse if the owner leaves. The professors talked about this risk of collapse when they said an owner needs to find someone outside their firm who can both buy their company and take over its management – this risk results in the lowest possible valuation.
By contrast, a business with the following qualities merits a much higher multiple:
- not owner-dependent
- vigorous lean systems
- competent management
- engaged employees
- a solid 10-year track record of 18% EBITDA growth
It is only common sense that an investment with an 18% return, is worth much more than an investment with flat growth.
The Harvard professors said a larger business has a multiple of 6-12x, but it seems that actual multiples in the market may be higher. In 2019 Bain and Co. prepared a report on actual large private business sale multiples in the US. They found that the average multiple was 11.5x, and that over 55% of US buyout deals in 2019 had a multiple above 11x.
The fourth ingredient is the Multiple: 10x.
To determine how we fared in terms of 10x-ing our value we must review the Starting Valuation, which is based on the numbers in the HBR case study: EBITDA of $1,000,000 x 4x = $4,000,000.
Combining our ingredients
- Starting EBITDA $1,000,000
- EBITDA growth rate 18% per annum
- Compounding period 10 years
- Ending Multiple 10x
Valuation at the end of the 10-year Target period:
$1,000,000@18% for 10 years = $5,233,840.00 x 10x = $52,338,400.00
That’s how 10x-ing value works.
John Mill, Mindset Coach Intelligent Work June 1st, 2021, Toronto ON
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