Privately owned businesses are typically sold on the basis of a multiple of earnings. Earnings for this purpose are expressed in a formula called EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA is adjusted by adding or subtracting income and expenses that impact the owners of the business but not prospective buyers, e.g., excessive salaries and perks for the owners. The resulting adjusted number represents the ongoing earnings stream likely to be experienced by a new owner.
The multiple times adjusted EBITDA is the value of the business to the buyer. Inherent in the multiple is the risk level assumed by the buyer.
Multiples may range from 2 to 10 for most private companies. The lower the multiple the higher the risk.
Where the company falls in that range depends not only on the risk level, but on the identity or characteristics of the most likely buyer. Generally there are three types of buyers, strategic buyers, financial buyers, and related buyers. A strategic buyer, typically one in the same or similar industry, may pay a price based on a higher multiple because it can realize certain synergies when combining the two companies. A financial buyer will pay based on a lower multiple, and a related buyer, e.g., members of the management team will pay based on a still lower multiple.
To increase the value of the company, owners will present their earnings as favorably as possible in terms of risk. Owners will emphasize the strong qualities of the company. But the significance of those strong qualities depends on the characteristics and perceptions of the most likely buyers.
So the first step in the process of increasing value is to identify the most likely buyers and ask them what drives value for them and what reduces risk. If you can improve those things, you can be on the path towards maximum value.
