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If you have been thinking about buying or selling a business, one of the first things you have probably been told is to make sure the business valuation is the correct "multiple".
So what does that mean, how important is it, really, and are there better factors to consider?
The value of a business can be calculated in several ways, one of which is as a multiple of cash flow (CF). For example, if a business has $500,000 in CF, and the industry standard multiple is 2.75, then you can expect that business to be valued at approximately $1,375,000. Anything more and it is "too expensive", and less is a "great deal". Or is it?
In our humble opinion, there are more important factors to consider when deciding if a business valuation is in the right range.
Functions of CF
The CF of a business needs to do 3 things for a buyer:
- Pay them the salary they need to maintain their standard of living
- Service debt
- Provide a decent ROI on the down payment
If the CF can do that comfortably, then the multiple is irrelevant. This means that not every business is going to be a good fit for every buyer.
Bank Debt Service Coverage Ratio
If the sale is going to be financed with an SBA loan, then we must take into consideration the bank's debt service coverage ratio requirement. The debt-service coverage ratio (DSCR) measures a business' available CF to pay current debt obligations. The DSCR shows lenders whether a company has enough income to pay its debts. The ratio is calculated by dividing net operating income by debt service, including principal and interest.
This usually ranges between 1.2 and 2, and describes the CF available to the buyer after debt service. For example, if the DSCR is 1.2, this means that the business can cover it's total debt 1.2 times over the current year.
So, if the CF can cover the bank's required DSCR, why does the multiple matter?
In determining the value of a business, it is important to consider comparable sales. Professional business brokers have access to national databases that provide information on historical sales by date, industry, price to revenue, price to CF, and other variables.
Gaining an understanding of what businesses in a particular industry have sold for is a valuable guide for pricing a business. This is an indication of the actual market, and not just random generic multiples.
So, if you are considering a business sale or acquisition, maybe don't worry as much about the multiple of the business, but rather focus on:
- Can this CF pay me the salary I need?
- Can this CF service the debt?
- Does this business have an established history?
- Are there opportunities for growth?
- Is there a strong foundation and team in place?
- Can I see myself running this business?
- Will I be able to have a good quality of life?
- Is there a lender willing to finance the sale?
- Is the asking price within the range of comparable sales?
These questions can help you determine if a business is a good fit for you.
Of course, the professionals at Starwood Business Group are always happy to help!
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