Basic Valuation Question re: Working Capital
March 25, 2022
by a searcher from University of Virginia-Darden - Darden School of Business in Richmond, VA, USA
When we say that most small businesses sell for 3-5 times EBITDA is that with or without their working capital? Does the working capital explain much of the range between the 3 and the 5? I’m curious to hear from others because I don’t have enough data points on my own to know this. I only know the deals I’ve worked on.
from Boise State University in 800 W Main St, Boise, ID 83702, USA
The second part of your question stating that "most small businesses sell for 3 to 5 times EBITDA". Again, define "small". In my experience most businesses valued under $5,000,000 are valued using SDE (Seller's Discretionary Earnings) which is EBITDA plus normalized compensation for one working owner. Most of the databases for "small business sales" do not track EBITDA. The only one that does is DealStats. Even in DealStats, most "small" companies don't report (or even show EBITDA) but they show SDE.
Finally, like everything, the deal structure matters. Most of the time, given the parameters of a business valued under $5,000,000, it will be SDE and the SDE multiple also depends upon how the subject company compares to the selected comparables. To select the "best" multiple for a particular company, I recommend selecting a range of comparables (at least 15), with revenues slightly smaller and some slightly larger. Then do a regression analysis on both revenue and SDE. Look at the percentage of SDE to revenue. Selecting a different data set will change the multiple.
Putting all "small" companies into one bucket and applying a "rule of thumb" (known as R.O.T.) is a back-of-the-napkin process that you'd only rely on if you had no data and the seller and buyer were uninformed.
P.S. the "rule of thumb" for SDE multiples for most "small businesses" is 1 to 3. :-)
from University of Colorado at Boulder in Georgetown, CO 80444, USA
I spent time teaching working capital to MBA students the last few years....
I feel like you're actually asking two questions:
1. Working Capital: I like to think of it as the lubricant that makes the machine generate profits. For example, are you heavy on receivables? you may be "profit rich" but "cash poor" for long periods of time. This creates an inherent risk if you don't apply enough "working capital" to get you through the time between a sale and a collection of cash. Nothing is worse than not having the cash to make payroll while your client is 2 weeks late on a payment. I've seen tons of businesses lack the "working capital" and/or financing to get them through the pay cycles. By the time the client pays, your business may have missed payroll or worse. As you grow you (generally) need to add to working capital. Most of the deals presented in the lower middle market sell you the existing working capital. Diligence is key to ensuring the WC they sold you is accurate.
2. EBITDA vs. Free Cash Flow and the "valuation" When I acquire businesses, I like to pay 2.5x to 5x Free Cash Flow (not EBITDA). Free cash flow is calculated as follows: EBITDA - Change in WC (this should be a % of Sales target) - Capex + Depreciation (less taxes) + interest paid (less taxes). When I bid businesses to a seller, I make my offer based on the reported EBITDA in the CIM and the amount I'm willing to pay. (For example: CIM EBITDA = $1 Million, Free Cash Flow (our calculation) = $1.6 million, 2.5xFCF = $4 million, Offer = 4x EBITDA even though you can pay this off in 2.5 years, which should allow you to achieve investor goals.
The use of debt increases the riskiness of the asset (as your breakeven increases), which is why I look for opportunities where I believe we can average 10% sales growth each year for the next 5 years -or- we can achieve a 3 to 5% COGS improvement over the next 18 months (with no sales growth required, great way to acquire 'bolt-on" acquisitions)
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