Like any small business owner, you want to know how much your business is worth. Once you receive an estimate, the next question may be, “how was this calculated?” A multiple is a number you would use when calculating the value of a business. You can use a multiple in many valuation methodologies. Before we dive in, it is important to understand the basics of one of the most common valuation methods for businesses that generate less than $5,000,000 in annual revenue.
Multiples are integral to calculating valuation using Seller’s Discretionary Earnings
While there are a variety of ways to calculate the value, for most small businesses, the Seller’s Discretionary Earnings approach is commonly used. This approach uses the net profit, add-backs, and owner’s salary. When you add these together, you arrive at the Seller’s Discretionary Earnings (you can learn more about add-backs, Seller’s Discretionary Earnings in our Resources section)
Net profit + owner salary + add-backs = Discretionary Earnings
To determine the value of a business, multiply the Seller’s Discretionary Earnings (SDE) by what is known as a multiple. A multiple will have a range. For example, it may be 1.1 or 1.3, or 2.3.
Discretionary earnings x multiple = estimated value of the business
Multiples vary based on the type of business or industry
So, what is the right multiple to apply to your business valuation? Well, it depends. Typically it starts with industry and then a sub-category within that industry.
Industry > Services > Printing > Commercial
There are many data combinations used to determine multiples because these combinations account for different types of businesses in various industries with differences in profit margin and growth rates. In our example, a commercial print business may have the same revenue as an e-commerce business however, the e-commerce business will likely have higher profit margins and anticipated growth rates, therefore, a higher multiple.
This data combination will give you a multiple which allows a potential buyer to see a calculation of likely future cash flow from the business and expected return on their investment. Here are some benchmarks according to GCF Market Data, a firm that supports analysts and business brokers.
* SDE = (Seller’s Discretionary Earnings)
Now let’s apply all of this information above to two examples in which the lower end of the multiple ranges applies to the Seller’s Discretionary Earnings.
Applying a multiple to something other than SDE is another approach to determining the value of the business. For example, using a multiple applied to Earnings Before Interest Depreciation and Amortization (EBITDA), or the Net Revenue, is another approach, which may change the multiple you use. To establish an objective number, take the time to research what multiple to apply or get the advice of a professional business analyst. Remember, you and the buyer will need to agree on this number, as it is a driver in the price of the business.
Agreeing to a multiple with a prospective buyer
Selecting a multiple that you and your prospective buyer agree on can present challenges. For one, your business may have unique characteristics that do not necessarily fall into a common industry or sub-category. For example, let’s say a printing business focuses on selling equipment to bakeries to print images onto cakes based on an image or photo.
In this case, the printing company will use a multiple different from a standard commercial printing multiple that is based on businesses that serve corporate clients purchasing marketing materials, business cards, and stationery.
Location can be another factor that makes a difference. For example, being located in a fast-growing market may result in you using a higher multiple versus a declining market, where you would use a lower multiple.
When a seller and prospective buyer engage in the negotiation process, the multiple applied to the business valuation is often part of the discussion. While the buyer sees value in the business, there is little incentive for them to apply a higher multiple leading to a higher price.
The buyer will want to use the lower multiple whereas the seller will want to apply the highest multiple possible. If this sounds like it is subjective, depending on whatever number the seller feels like choosing, it is – to some degree. It’s very wise to start your negotiation using the industry most closely related to yours.
Using that industry’s multiple ranges gives you a reasonably narrow baseline for negotiation. For example, it is easier to discuss what multiple is most appropriate in the range between 2.8 and 3.5 versus a more arbitrary approach where the multiple ranges could be anywhere from 2.5 to 4.5.
The multiple is a critical part of establishing value for your business. So important, in fact, that brokers, analysts, and others in the financial industry often ask, “what’s the multiple?” when discussing the value of a company. Based on their experience, it’s a good way to quickly determine if the multiple used is reasonable, and therefore the valuation is realistic.
Even if you are not the one performing the valuation for your own business, it’s vital for you to understand what multiple is used. It can make a big difference in the sale price, and money in your pocket.