For a host of reasons, a founder may ask themselves: what is my business worth? This is a common question among founders. Maybe you’re in the middle of doing some estate planning. Or perhaps you’re just curious about what you could get if you sold it.
The catch is that there are many ways you can think about valuation. And, no matter what you heard from the guy you met at a cocktail party, it’s probably not one-times your sales. The truth is that there are a couple of factors you need to consider as you think about the actual value of your business.
Here are some factors that can play a role in coming up with that number.
Multiple Of EBITDA
The most traditional way to come up with a back-of-the-envelope value for your business is to use a multiple of your EBITDA (earnings before interest, taxes, depreciation, and amortization), which is a measure of the free cash flow generated by the business. For small businesses, the multiple might be as low as 3; for large companies in hot industries, the multiple could be as big as 6 to 8 times EBITDA. This multiple works well with companies that have begun to slow their growth but also generate a lot of cash.
You can use some reverse logic to help understand how a buyer might arrive at a multiple. (I’m also going to ignore the use of debt here, which I’ve written about before.) The inverse of the multiple equals the rate of return the investor can expect to generate. For example, if a buyer pays a 10-times earnings multiple to buy the business, they can expect a 10% return on their original investment. In other words, the lower the multiple the seller pays, the more return they can generate on their investment. I’ve written before about how you can apply some “window dressing” to your business to boost EBITDA before a sale. But your decisions should always be to build the best company for the long run.
Multiple Of Sales
It’s rare to see a company valued based on multiple sales, but it happens. Typically, it involves hyper-growth companies in white-hot markets. They generally don’t have a lot of earnings because whatever they earn, they plow right back into growing the business. Their business models are designed to increase and capture market share, not make money. They’re built for a land grab.
So, when you see companies valued on sales, the multiple might be a big one–maybe even as high as 12 times sales if it’s a SaaS company with a robust recurring revenue business model. Fintech firms reached valuations of 22 times revenue in late 2022. That number will typically come down as the company matures and its growth slows.
Think about what happens when you go to sell a home. A real estate broker will first look for “comps” or houses like yours–the same number of bedrooms, lot size, garage, etc.–and see what they sold for recently.
If you hire a broker to help sell your business, they’ll do the same thing. If a company that looks and operates a lot like yours in the same industry sold for five-times revenue, then chances are you can expect to trade for something in the same range if everything else is equal. That local knowledge of why a company got an exceptionally high or low valuation is critical for the broker to set the right price expectations.
The tips I’ve shared apply to so-called “financial” buyers or people looking to buy your business to generate a return. But there are also “strategic” buyers who might be interested in your business. And this can be a good thing. A strategic buyer is someone, likely another company, that sees value in combining aspects of your company with theirs to gain new sources of revenue, access to new customers, or cut costs with operational efficiencies. Depending on the situation, selling to a strategic buyer can be advantageous because they might be willing to pay more than a financial buyer because of the synergies. This can feel dangerous to a seller because they are likely disclosing details of their business to a competitor, but it might land the highest price.
One of the most challenging aspects of valuing a business from a seller’s perspective is understanding that a seller isn’t paying you based on your expectation or even promise of future “hockey stick” growth. No buyer wants to pay for something you haven’t yet demonstrated the ability to do or a revenue curve that knees skyward immediately after they purchase the firm. That means if you think you’d be selling low at the moment, you have two options to consider:
B. Agree to accept what’s known as an “earnout,” which is a promise of future payment to you from the seller if the company reaches specific growth or performance goals.
Either way, you’ll have to put your money where your mouth is if you want compensation for what might happen.
A Valuation Quiz
If you’re curious about how much your company is worth, consider how your business fits into any of the categories I’ve laid out above.
Are you more likely to be valued based on your earnings or sales?
Would you prefer a financial buyer–or a strategic one?
And if you believe your company is ready to take off on a rocket ship, should you stay for the ride?
How you answer these questions will tell you a lot about the value of your business.