When preparing to sell your business, assembling a team of advisors and brokers is key. They have the legal knowledge and expertise to secure you the best deal possible. One of the first things that your team of advisors is going to do is complete a company valuation to determine what your business is worth.
To do so, your advisors will utilize valuation multiples, which help determine your company’s market value relative to competitors in your industry. One possible multiple that your advisors may consider using is a revenue multiple.
In this article, you’ll learn what revenue multiple valuations are, how they work, and the scenarios in which advisors would use them to determine the value of a company. By the end of this article, you should have a much better understanding of revenue multiple valuation and how it may impact businesses in the lower middle market (those with revenue between $5 million and $25 million).
What Is a Revenue Multiple Valuation and How Does It Work?
A revenue multiple valuation is one that relies on a company’s gross revenue. Gross revenue is equal to the total amount of sales for a particular period, often measured annually. The revenue multiple formula is:
Revenue Multiple = Enterprise Value / Annual Revenue
Enterprise value refers broadly to “the value of a company.” While it’s important for business owners to understand the value of their largest asset, business brokers also use Enterprise Value when determining how to price a business for sale and evaluating buyer offers.
If your advisor is conducting a revenue multiple valuation, then the formula would generally be as follows:
Market Value = Annual Revenue x The Average Multiple of Revenue for Your Industry
If your advisor is going to conduct a revenue multiple valuation, they will first gather the multiple of revenue for your industry. For instance, let’s say that your business manufactures commercial signage (NAICS 339950) and typically does $4M in annual sales. According to PeerComps — which collects data from closed transactions that used SBA financing – the median revenue multiple for your industry is 0.71.
Your advisor would multiply $4,000,000 by 0.71 to yield your company valuation of $2,840,000.
Not all industries use revenue multiples to determine value. In fact, most do not. In these cases, your team of advisors will need to perform a multiples analysis to help find your market value relative to your competition. This can be tricky if the company is not public and does not have stock prices available.
Hiring a team of trusted advisors can ensure your valuation is accurate. If an advisor provides a higher multiple than is correct, you’ll end up thinking that your company is worth more on the open market than it truly is. This can lead to the valuation gap, which can quickly become a liability during the merger and acquisition (M&A) process.
Again, using a multiple of revenue metric to value a small business is usually limited to certain industries, and does come with some downsides.
When Do Advisors Use Revenue Multiple Valuations?
There are only a handful of scenarios where your advisors would use a revenue multiple valuation. This type of valuation is not the norm and typically only applies to certain industries or business models. Specifically, it’s often used for industries that have minimal overhead and assets and instead carry a “book of business” — a list of clients or accounts that buyers want to acquire. A few examples include:
- Property management companies
- Insurance companies
- Accounting and tax firms
- Financial advisory firms
These companies may own an office and some equipment, but their buyers likely aren’t interested in those assets. Instead, the buyer is probably interested in absorbing the company’s clients or customer list.
For instance, in the above scenarios, buyers interested in purchasing a property management company may focus on the number of tenants, leases, or “doors” being managed. Likewise, buyers interested in a tax practice are likely interested in the number of tax returns versus audits performed annually.
That said, your advisors may need to use other criteria alongside the multiple of revenue. If you own a life insurance company, for example, the value of the company may be impacted by the ages of the policies and policyholders.
Consider commercial property and casualty insurance companies as another example. If you have one of these companies, the buyer will typically want a book of business that is diversified across a variety of industries, product lines, policy types, and geographies.
One last scenario where advisors may also use a revenue multiple valuation is for startups or early-stage companies. These businesses may have expenses that are disproportionate to their sales and have not yet reached full profitability.
For instance, if a company was founded within the last year, their expenses for things like overhead, research, development, and marketing could be high. The company could even be operating at a loss.
However, just because the company is operating at a loss doesn’t mean that it’s worthless on the open market. In fact, a strategic buyer may come along and show interest in buying a company based on factors like a concept or intellectual property. This is rare, though, as most buyers in the lower middle market are financial buyers.
Using a financial metric like the revenue multiple could be useful in some circumstances. But it only measures sales and does not consider things like free cash flow or expenses. Your advisors are likely to use other benchmarks to determine the value of your company.
What Else Should Sellers Be Concerned About Besides Revenue Multiples?
Revenue multiple valuation comes with some downsides. It’s very easy to say something along the lines of, “My business is worth two times gross sales.” Doing so inherently demonstrates one of the main limits of revenue multiple valuations — they’re essentially a fancy way of measuring gross revenue. Gross revenue does not tell a company’s whole story, and buyers may push back if a multiple of revenue is the primary source of the valuation.
Buyers will still care about Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and EBITDA multiples. That’s because EBITDA more accurately represents a company’s operational health and profitability. EBITDA multiples are more commonly used in the lower middle market. A quick breakdown on the things you should be concerned with:
- Earnings: Also commonly referred to as Net Operating Income. This is the amount of pre-tax profit remaining after subtracting your expenses and costs of goods sold.
- Interest: The cost of borrowing money from a lender. These are the financing costs associated with any debt you have.
- Taxes: Includes both state and federal business taxes.
- Depreciation: This is a non-cash expense used to calculate the cost of a tangible asset over its useful life.
- Amortization: This is similar to depreciation, except it refers to loans or intangible assets like Goodwill and intellectual property.
It’s important to remember that the value of a business is always affected by a number of things. Determining the value is never just a simple equation. Your advisors may apply various earnings multiples — as well as look at the prevalence of using a revenue multiple in your industry — to determine your company’s value.
Your Trusted Team of Advisors Can Help With Your Business Valuation
Conducting a valuation for a company can be challenging. A revenue multiple valuation is one of the more straightforward options, assuming there’s a widely-accepted multiple that is commonly used in your industry.
However, this valuation methodology is industry-specific. It’s not the norm for valuing businesses in the lower middle market. It’s primarily for those with a book of business or customer list. It can also be used as an alternative to discounted cash flow (DCF) for entrepreneurs who have startups that have not yet established full profitability.
Revenue multiple valuation may make it seem as though you can value your own company, but there are numerous factors that go into a comprehensive valuation. Experienced advisors will not only look at your cash flow, but will also consider things like your growth rate, profit margins, and customer concentration to accurately determine the value of your company.
If you’re looking to have a thorough valuation conducted, be sure to reach out to Allan Taylor & Company. Our team has more than 15 years of experience in the merger and acquisition industry and can help you meet your future business — and personal — goals.
