Anyone who has considered buying or selling a lower middle market business quickly becomes familiar with the term “multiple of adjusted EBITDA,” or the concept that valuation is often based on a multiple of earnings. The appropriate multiple for any particular business can vary, with higher multiples for more attractive businesses, and lower multiples for less attractive businesses.
For example, take hypothetical Business A and Business B, both of which generate $1M in adjusted EBTIDA. Business A is on the market for a 3x multiple, or $3 million; and Business B is on the market for 5x multiple, or $5 million.
Why would anyone pay $5 million for Business B that makes $1 million, when you could buy Business A, that also makes $1 million, for $3 million? Is the $3 million business a bargain? Or is the $5 million business overpriced?
Both are possible, given the limited price transparency in lower middle market transactions. But let’s assume that the businesses are actually priced correctly. What does a 3x multiple or a 5x multiple really imply about the historical performance and future growth expectations of each business? Is Business A a better deal than Business B?
As a first step, consider the multiple in terms of rate of return on each investment.Specifically, the implied expected rate of return on the investment is the reciprocal of the multiple.
·A company with a 3x multiple, implies an annual future return of 1/3 or 33.3% per year.
·A company with a 5x multiple implies an annual future return of 1/5, or 20% per year.
So a buyer who is ready to pay $3 million for Business A is expecting an annual rate of return of 33%, assuming the business continues to generate $1 million each year. The buyer for Business B at $5 million is expecting an annual rate of return of 20%, assuming that business also generates $1 million per year. Both are high returns compared to most publically traded investments. But of course, return is typically correlated with risk, with risk here primarily defined as the chance that income will decline below $1 million per year.
Higher return = higher risk. Lower return = lower risk.
The pricing of these two businesses implies that the business with the higher return, Business A, is more risky than Business B. To be compensated for taking on more risk, a buyer would pay less for it. Business B is less risky than Business A, and therefore the buyer would pay more for it.
As a seller, figuring out how to reduce the chance that income will decline in your business can (in a perfect world with perfect pricing) help generate a higher multiple in a sale. As a buyer, understanding your required rate of return and the level of risk associated in a transaction can help ensure you pay an appropriate price for any business.
Let’s look at some factors that potentially reduce risk (and increase multiples) in lower middle-market businesses. They include:
- Historical performance. A strong track record of consistent financial performance provides the buyer with reassurance that the company should continue to do well.
- A contractually recurring revenue model. Ongoing client contracts imply the company will continue to generate revenue.
- Strong gross margins help ensure the business will have sufficient cash to cover fixed expenses and still generate a profit.
- A well regarded brand indicates that customers think highly of the company, and are likely to continue to purchase from the company.
- High barriers-to-entry can prevent future competitors from taking away business.
- A strong management team indicates less reliance on one or two people.
- Organized systems and financials imply less potential for nasty surprises for a buyer down the road.
Conversely, factors that increase risk (and reduce multiples) include:
- Customer concentration issues. Lose one or two big customers and you’re in trouble.
- Historical fluctuations in financial performance. If revenue and income have historically bounced around, what will happen in the future?
- An industry with declining demand or low growth. How will the company continue to grow?
- High capital infrastructure requirements could be a drag on cash flow.
- Reliance on a short-term lease. What happens if the landlord won’t renew?
These are just a few examples, and you can probably think of many more factors that increase or decrease risk. This type of analysis also helps us understand why some industries generally receive higher multiples than others.
While this overview seems simple, each transaction typically has additional layers of complexity. For example, buyers often bring synergies to a transaction that can reduce the risk in a business. Or when leverage is involved with financing the transaction via a seller note, some of the risk of the transaction is transferred back from the buyer to the seller. This is why deals with a seller note often have a higher valuation multiple than those with no note. Finally, actual terms on the transaction are not always completely or accurately tied to risk and performance of the business. Not every seller or buyer has adequate information or reasonable expectations regarding the price of a business given the level of risk involved. Some sellers may be more motivated than others, and the external economy and demand for investment opportunities also drive buyers’ willingness to pay higher prices.
Another additional consideration and implication for valuation multiples is anticipated future growth. We will address this in a future article.
As always, there is much more we could add here! But we hope this is some initial food for thought, and please feel free to reach out with any questions or comments.
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The article you shared delves into the concept of business valuation based on the multiple of adjusted EBITDA. It's crucial to grasp the intricacies behind these multiples and their implications for buyers and sellers in the lower middle market. Here's a breakdown of the concepts:
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Adjusted EBITDA Multiple: This is a key metric used in valuing businesses. It represents a factor applied to a company's adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) to determine its overall value. The multiple varies based on the perceived attractiveness and risk associated with the business.
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Valuation Variations: Businesses with higher perceived attractiveness generally command higher multiples, while less attractive ones have lower multiples. This distinction is evident in the example of Business A and Business B, both generating the same $1 million in adjusted EBITDA but being priced differently due to their perceived risk levels.
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Rate of Return and Risk: The multiple implies the expected rate of return on the investment. A higher multiple means a lower expected annual return, suggesting lower risk. Conversely, a lower multiple indicates a higher expected annual return, signaling higher risk.
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Risk Factors and Multiples: Various factors impact risk and consequently affect the multiples. Factors that reduce risk, such as consistent financial performance, recurring revenue models, strong margins, brand reputation, barriers-to-entry, competent management, and organized systems, tend to increase multiples.
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Factors Increasing Risk: On the flip side, factors like customer concentration, historical income fluctuations, declining industry demand, high infrastructure requirements, lease dependencies, among others, tend to reduce multiples by increasing perceived risk.
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Complexities in Transactions: Beyond these factors, each transaction involves added layers of complexity. Buyer-seller dynamics, the introduction of synergies, financing structures (like seller notes), and varying perceptions of risk and performance influence the final valuation.
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Future Growth Considerations: Anticipated future growth also plays a role in valuation multiples, impacting a company's perceived risk and attractiveness.
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Price Transparency and Market Dynamics: Limited price transparency in the lower middle market influences the perceived value of businesses. Seller motivation, market demand, available information, and economic conditions all contribute to buyers' willingness to pay certain prices.
The article highlights the significance of understanding risk, performance, and future growth expectations when assessing business valuations. It emphasizes the nuanced nature of transactions and the multitude of factors influencing valuation multiples in the lower middle market.
