“I sold my business for a Ten Multiple.”
We hear this, or something close to this all too frequently. A 10X is possible (although as of 2019, highly unlikely), but to truly understand what this lucky person allegedly received, we have to know:
- What the multiple is based on, EBITDA, Adjusted EBITDA, Gross Margin or Revenue.
- The structure of the transaction (percentage of the price paid in cash at closing vs. the balance and how it’s leveraged).
- How much working capital was left in the company for the Buyer.
- When and where it occurred.
The metric depends on the type of company
For publicly owned companies, the most noted metric is a multiple of after-tax net income and it’s often applied to projected income over the next twelve months.
For established private companies, like most staffing firms, the most commonly used valuation metric is a multiple of the trailing twelve month Adjusted EBITDA (for profitable firms). If the firm is running at a loss, a multiple of gross margin (or possibly revenue) could be used.
For early-stage companies, it’s often a multiple of revenue primarily, for two reasons:
- They are often not profitable at this stage but are expected to be in the future once their product or service is proven out or;
- They are in high growth mode and profit levels are depressed as a result of higher than long-term average spending on research and development (R&D) and product/service marketing.
EBITDA stands for earnings before interest, taxes, depreciation and amortization (if any) and it therefore allows for a fair comparison between companies because it negates the following four effects on profitability:
- The effect of having different asset bases by cancelling depreciation;
- The effect due to different takeover histories by cancelling amortization often stemming from goodwill;
- The effect due to different tax structures; and lastly
- The effect of different capital structures by cancelling interest costs.
Adjustments to EBITDA, create AEBITDA (Adjusted Earnings Before Interest Taxes Depreciation and Amortization). These adjustments (credits or debits) impact EBITDA negatively or positively, depending on the circumstances in the business. Adjustments to EBITDA include profit:
- Expenses that are identified in the
trailing twelve-month P&L as legitimate business expenses required to run
the business but can be classified as a 1-time expense, meaning not expected to
re-occur in the next 12 months (or beyond to some extent). Examples include:
- Professional, legal, audit fees associated with a 1-time undertaking, project, consultation, etc.
- Funds paid to settle a claim of some type (Lawsuit, Workers Comp, EEOC, etc.).
- New technology acquisition/implementation. While some of these types of expenses could be considered one-time, they will be tallied against the cost to maintain, upgrade or even replace the technology by the Buyer, once the transaction is closed. Sometimes these expenses are included in the Depreciation and Amortization sections of the income statement and are automatically reversed out when D&A are removed from EBITDA and are not double-counted as additional “add-backs”.
- Special events and/or event related costs.
- Penalties that are levied on an exceptional basis.
- Discretionary expenses such as charitable donations, event/party expenses, memberships and dues can be reversed from expense to increase profit, provided that the discontinuation of any of these items will not adversely affect the business. This is an area of adjustments which is often negotiated between the Buyer and Seller during the early stages of the transaction.
- Compensation for Owner(s). This is a trickier one to calculate. First it must be determined what role the Owner(s) is fulfilling in the business. If it’s a role the Buyer would need to have someone continue to perform, the Buyer will determine what it’s going to cost them to have someone (or something) perform that function and if it’s less than what the Seller has taken out in Compensation expense, EBITDA would be increased by the difference. If the Buyer determines it’s going to cost them more than the Seller has been taking in compensation from the P&L, EBITDA will be reduced by the difference. Obviously, this adjustment, like the previous one is somewhat subjective.
- Other Owner-related expenses may be
included as add-backs include:
- Key life insurance,
- Special health benefits,
- Non-business-related travel, meals, entertainment, subscriptions, memberships, tickets, donations, etc.,
- Personal items run through various parts of the SG&A section of the Income Statement.
- Office(s) rent: If the Seller owns any property they are renting back to their staffing firm as workspace, the rent paid may not be at fair market value. A negative or positive adjustment may be required to normalize the rent expense going forward.
Adjustments are often thought of as containing fluff used to boost profitability, so be sure you can verify and justify all items that you are proposing to add back. Be prepared to have these items carefully examined and potentially “re-adjusted” by the Buyer.
The timeframe matters
The period the multiple applies to is also important. While Valuation is conceptually a forward-looking principle and publicly owned firms will often present their earnings on the next 12 months performance; for most privately owned companies the time frame is generally the Trailing Twelve Months (TTM) performance as a result of the difficulty in predicting what the next 12 months of earnings may be.
- As mentioned, the structure of the transaction (percentage of the price paid in cash at closing vs. the balance and how it’s leveraged) can have a huge impact on the multiple ultimately paid. Typically, an asset purchase or stock purchase will have some amount of the target price paid as cash at close. Sometimes, vested or unvested stock may be included in the “down-payment”. The balance of the target price is subjected to a note, series of notes or an earn-out.
- Notes are based on two things: the passage of time and the Seller complying with the terms of the note (this usually revolves around the Seller signing a non-compete). Because this is a form of Vendor financing, interest should be calculated on the principal amounts owing. Interest and principal payments are paid on an agreed-upon schedule.
- Earn-outs: This is where the balance of the target price not yet paid is dependant upon certain things (usually revenue or gross margin) being sustained or improved on for the term of the earn-out. If targets are achieved, the earn-out payment is paid. If results fall shy of the target for the earn-out period, a reduction (not elimination) of the earn-out payment to the Seller applies. If the target is surpassed, a premium, in addition to the set earn-out payment should be paid to the Seller.
More cash at close with the balance on a less-risky-to-the-Seller note(s) generally lowers the multiple of AEBITDA offered. Less cash at close and/or the balance being on riskier-to-the Seller earnouts will support a higher multiple. Sellers seeking 100% cash on closing will take deep discounts if they can even find a Buyer. What is actually paid and what the final multiple is, can only be calculated once the deal has lived its entire lifespan.
Other Considerations in determining Value and multiple paid:
- Did the Buyer assume any of the Seller’s debt?
- Were working capital adjustments made?
- Over what time frame was the purchase price paid?
- Are there claw back features if the business becomes less profitable?
All of these questions will impact valuation and the amount the Seller receives over time.
So, the next time someone tells you they sold for a ten multiple, focus more on the total value that was received, since we can’t spend a multiple, we can only spend the cash in our pockets.
A multiple is just one-way to express value however as we can see from the questions above, what is counted in a multiple can vary a great deal due to the circumstances of both the Buyer and Seller.
When we actually probed one very proud Seller about his ten multiple that he kept bragging about, we learned that his multiplier was applied to all of $1,500 dollars of adjusted EBITDA, so his ten multiple was real; however it amounted to all of a $15,000 purchase price.
So, focus on the dollars you will end up with and try not to get hung up on the multiple, after all it is only a number without context unless you have a more complete picture of the transaction.