De-Mystifying Multiples

Two business women reviewing financials.

De-Mystifying Multiples

Multiples can be tricky to figure out when valuing a business. Lots of opinions float around, most stemming from imperfect information. For example, Aunt Agatha’s hairdressers say that her husband’s cousin sold his widget manufacturer for three million dollars based on a multiple of five. What the hairdresser didn’t mention is that this price included $800,000 worth of inventory – an amount well above the industry average. Misunderstanding the details of a deal can lead to unrealistic pricing expectations or undervaluing your business.

So, what is a multiple? Essentially, it is a number by which you multiply the economic benefit enjoyed by the business’s owner. For most small Main Street businesses, this is called Seller’s Discretionary Earnings (SDE), reflecting the owner’s active role in the business. In larger businesses, this benefit is often expressed as EBITDA—Earnings Before Interest, Taxes, Depreciation, and Amortization. In addition to EBITDA, SDE includes the owner’s salary and any personal expenses run through the business, such as personal auto expenses, the family’s cell phone plan, and personal travel.

An Example of Multiples in Action

Let’s say you are selling your medium-sized business, Widget-O-Rama. Among comparable widget manufacturers, the average sales price is $1,750,000, while the average SDE is $550,000. This results in an SDE multiple of 3.18. In other words, $1,750,000 divided by $550,000 equals 3.18.

If your business’s SDE for the last three years averages $545,000, but this number has consistently increased year over year, you may be able to assign a higher value to your most recent year. However, this only applies if the increase is predictable and sustainable, and not due to external or one-time factors (e.g., a global pandemic or a massive, non-recurring order). By weighting the most recent year more heavily, you can reflect your business’s impressive performance and justify a higher price.

Multiples Are Only as Good as What They’re Multiplying

Further adjustments may be needed to come up with an accurate SDE. For instance, both you and your partner play equally important roles in running Widget-O-Rama. While you’re out front overseeing production and ensuring quality control, your partner is handling the bookkeeping, ordering raw material, and calling delinquent accounts. Together, you earn $250,000, but to replace your partner at a Fair Market Wage would require hiring a financial manager for $60,000. In other words, the officers’ salary expense needs to reflect the cost of having just one person run the business. Thus, the officer’s salary would be reduced by $60,000, which would reduce SDE by an equivalent amount.

Or the business’s growth has necessitated moving to a larger facility that will allow Widgets-O-Rama to increase production to meet customer demand. Setting up the new plant involved significant one-time investments, advertising costs, and training expenses. Production also slowed down during the transition. The SDE will need to account for any one-time adjustments on the Profit & Loss Statement. While the SDE itself cannot capture the business’s anticipated increased earnings potential, a pro forma can.

Making these necessary and standard adjustments will help build the buyer’s confidence in your asking price.

Beyond Simple Metrics

This is a simplified example. In reality, the valuation process is influenced by factors such as the quality of financial records, market trends, client concentration, and the business’s dependence on the owner.

Multiples, no matter how fact-based, are not the end-all, be-all. A sophisticated buyer will also evaluate the income they’ll earn after debt service, based on their down payment.

The Role of Expert Guidance

Sam Goldenberg & Associates can help you navigate these complexities and sell your New Mexico business for a price supported by the market. Unlike anecdotal evidence from Aunt Agatha’s hairdresser, we have access to reliable sales data from financial institutions and certified business appraisers. This data aggregates actual sales prices of businesses and verifies the inputs that determine SDE.

Consulting a seasoned expert is invaluable to ensure your business is priced optimally to attract buyers and maximize your profits. Michael Greene’s insights and experience can bridge the gap between market expectations and realistic outcomes, setting the stage for a successful sale. To learn more, reach out to Michael at 505-820-0163 for an initial complimentary consultation.