Small Company Valuation
Ultimately, the value of anything being sold is what someone is willing to pay for it. There are, however, many accepted methods for determining value when it comes to your business: Book Value, Discounted Cash Flow, Multiple of Cash Flow and Multiples of something else—for example, some industries are valued at a multiple of subscribers, a multiple of revenue, etc.
Hadley Capital's Approach to Valuation
Hadley Capital values Companies based on their ability generate sustainable, operating cash flows. We typically apply a multiple to the annual, sustainable operating cash flow of a business to estimate its value. We use EBITDA as a rough but good estimation of operating cash flow. To determine sustainable cash flow, we adjust EBITDA to include some positive and negative add backs.
Positive add backs that increase EBITDA may include:
- Owners excess compensation
- Rental expense above market rates
- Owners benefits that are not required to run the business such as automobiles, vacations, etc.
Add backs that may decrease EBITDA include:
- Rental expense below market value
- Substantial annual capital expenditures
- Additional salaries required when the owner departs
A Valuation Tool
Once sustainable EBITDA is determined, Hadley Capital applies a multiple of EBITDA to determine the Enterprise Value of your business. In general, smaller companies typically trade for between 3x to 5x normalized EBITDA. The difference in the multiple is generally the result of a variety of characteristics specific to your business, including:
- Sales growth rate
- Gross Profit Margin
- Annual EBITDA
- EBITDA Margin
- Annual capital expenditures
- Working capital requirements
- Customer concentration
The Structure of the Offer is Important
Not all offers are the same or comparable. Some buyers may offer a higher "headline number", that suggests your business is worth more, but contingency payments like earnouts, seller financing requirements and complicated financing structures may add risk to the offer by stretching out payments over time rather than a single, substantial check at closing.
At Hadley Capital, we are private equity investors with capital on hand, which means that most of our transactions involve substantial cash at closing. We can structure payment using a variety of financing techniques but most sellers prefer cash even if our valuation appears slightly lower than a competing offer with complicated or protracted buyout contingencies. We are happy to discuss options and explain how price differences really work and how cash can pay added dividends.
Enterprise Value vs. Equity Value
Hadley Capital's valuations are almost always based on an enterprise value, rather than an equity value, and are usually on a cash-free, debt-free basis. As the seller, you are responsible for satisfying (paying off) any existing debts. Equity Value is what is left after subtracting debt from Enterprise Value. Enterprise Value and Equity value may be most easily understood by comparing them to someone's home value. The Enterprise Value of a home is the total value of the home. The Equity Value of the house is the total value less the mortgage on the home. It's the same with your business; Equity Value is what's left after you pay off any debts.
Working Capital Adjustment
Working capital is the capital required to operate a business in a steady state environment. Hadley Capital acquisitions always include a working capital adjustment at closing. A working capital adjustment increases or decreases cash at closing based on the performance of the business between executing a LOI and closing a transaction. If the business grows between LOI and closing, the working capital adjustment will result in higher sale proceeds because the working capital grows. If working capital declines, the purchase price will be lower. The working capital adjustment is not meant to benefit the seller or the buyer but, rather, to compensate for balance sheet changes (to the positive or negative) between LOI and closing.
Occasionally Hadley Capital will meet a seller that says "my business is for sale for $5 million plus the value of the inventory." It is not industry standard to value the two separately. Inventory is an asset of a business and is part of a company's Working capital and, thus, included in the Enterprise Value of a company.
In a cash-free, debt-free transaction, the seller of a business keeps the company's cash. Since customer deposits represent cash collected from customers for projects that are in process, it is standard practice to reduce sale proceeds by the amount of customer deposit liabilities because the buyer will need the deposits to complete projects in process. Since the seller gets to keep the cash associated with customer deposits, the result is a net zero impact on value.
An escrow is a hold back of a certain amount of the cash at closing to cover representations and warranties made in a purchase agreement. The size and term of an escrow will vary depending upon the transaction, but typically are 10% to 15% of the transaction value and are typically in place for 12 to 24 months.
Earnouts can be an effective way to bridge a valuation gap between buyers and sellers. Earnout payments are made to a seller based on the future performance of the business and based on a pre-determined calculation. Since earnouts are a form of contingent purchase price, sellers need to weigh the risks of waiting for the value of the business to increase versus accepting an all-cash offer.
A Seller Note (sometimes called Seller Financing or Seller Debt) is a debt obligation issued by a seller of a business to a buyer and used by the buyer to finance a portion of the purchase price. Seller Notes are often subordinated to other debt issued to a buyer to complete a leveraged buyout. Seller Notes are typically structured as a five year, interest bearing note. Amortization, or principal repayment, of a Seller Note, is usually over five years or as a lump sum or bullet payment at maturity.
» Check out the Acquisition Process Guide