There are Several Key Factors Affecting the Value of a Business

I recently wrote about the importance of a business’ cash flow in helping to determine its selling price. Once a business’ net cash flow has been identified, a “multiple” against that number is applied to establish the business’ value.

Generally, the lower the multiple, the higher the return on investment for the buyer. For example, a business where the buyer pays a multiple of three will see a 33 percent annual return on their investment while someone paying a multiple of two should expect to earn a 50 percent annual return.

In Northern Nevada, the majority of profitable, privately held businesses will sell for a multiple of between one and a half to four times their net cash flow. There are numerous factors that can impact the multiplier.

One of the significant factors is the type of business the owner has. For example, a manufacturing facility likely would have a higher multiplier than a service business. Because the ease of entry into many service businesses is easy compared to the capital costs associated with starting a manufacturing facility, buyers are prepared to pay more for the latter.

The profitability of two businesses in the same industry will have dramatically different multiples if one has a net cash flow of $100,00 and the other has $1,200,000. A good general rule of thumb is that the higher a business’ net cash flow, the higher the multiple.

There are a number of operational factors that can also have an impact. A business that has 80 percent of the revenues come from two customers will have a smaller multiplier than a business where no one customer represents more than 20 percent.

This reminds me of the client who was very proud to have taken his client base from a level of 18 to 20 customers down to two. Even though his profitability didn’t diminish with his new strategy, he never was able to sell the business because there weren’t any buyers who were prepared to risk losing approximately 50 percent of their revenues if they lost one client.

A business with strong market share will command a higher multiple than a weak competitor. For example, a Ben’s Liquors store would likely command a higher multiple than a corner liquor store.

If a business has key personnel in place, they will typically get a higher multiple than one who doesn’t. A typically buyer is generally prepared to pay a little more if the business has manager in place who can help with the transition. A good analogy is when buying a car, most people will pay more if it has an engine in it.

Franchises, especially those with multiple locations, can get a higher multiple compared to independent businesses. For example, the multiple that an independent restaurant netting $100,000 will likely sell for is smaller than a group of franchised restaurants who are each netting $100,000.

Where a business has been and where it is now can also have impact. Although most buyers are only prepared to pay a price based on current reality, if a business has shown steady growth over the past three years, a buyer may very well pay a higher multiple than a similar cash flowing business which is on a slippery downhill slope.

And finally, one key factor that is often overlooked is business owners who are prepared to carry a note as part of their deal. They undoubtedly will see a higher multiple. This is because buyers will typically expect a discount if they are paying cash for a business, which will translate into a smaller multiple.

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