Understanding Valuation in the Lower-Middle Market by Using Methods and Ranges
The Fast Answer: What is a Business Worth?
The basic yardstick for business valuation is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) adjusted for things such as growth potential, risk and market demand. In the lower-middle market, (or $1M to $100M in enterprise value), valuation is typically between 2.5x and 7x EBITDA.
Revenue rarely determines sale price. Buyers look at sustainable and transferable cash flow. They also focus on whether earnings will persist after the current owner leaves, Other industry factors, including market dynamics, customer concentration, management quality, and financial clarity also help determine where a business lands within this range,
Bottom line: A business is always worth what a qualified buyer will pay given the company’s quality, risk profile and competitive positioning.
What Business Owners Need to Know About Valuation
A business valuation is created by estimating what a privately-held company is worth in the existing market. In lower-middle-market deals (which Sun Acquisitions specializes in), valuation isn’t just related to top line revenue; it is derived from EBITDA, cash flow sustainability, employee quality and financial transparency.
Let’s look at some key takeaways:
- Most businesses are valued via EBITDA multiples which are also applied against adjusted earnings.
- “Comps” (or comparable deals) tell you what similar businesses sold for and have a strong impact on market pricing/value.
- Preparation and transparent financials can meaningfully boost valuations.
- How deals are structured and financed (plus buyer demand) also impact the final price.
We have found these factors are consistently present when private companies sell for under $100M, though other variables such as margins, growth potential and timing can also impact the final valuation.
Introduction
Failing to fully explore valuation before a sale is already in process is one of the most common errors business owners make. Smart owners know that valuation is most useful when explored early. Businesses are fundamentally worth what a buyer is willing to pay today, regardless of any owner’s belief or formula used to arrive at a valuation.
This sometimes creates a disconnect between perception of value and true market value. Experienced M&A pros often deal with owners who painstakingly build a company for years and who become anchored to benchmarks such as total money invested, sweat equity or an industry comparable. Buyers, however, are captive to no such sentiment. They look at risk, ROI and other deals, so understanding how to value a business to sell is crucial for any successful, timely transaction.
In this article we will examine core valuation techniques and the factors that make multiples rise and fall. We’ll also look at how owners can best position themselves to capture the best possible value.
What Business Value Really Means
Business value boils down to fair market value: The price where buyer and seller meet if both have a good grasp of the relevant facts. This isn’t a calculation derived from accounting principles but an estimate that is driven by the market itself.
It’s important to note that fair value is not a static concept. A company with 4x EBITDA during a favorable M&A cycle may trade at 3x if buyers become fewer or credit gets tighter. The clarity of financials, buyer risk assessment and other buyer alternatives may also shift valuation.
If you’d like to learn more about this specific concept, we invite you to take a closer look at how to value a business for sale, which includes more context on expectations vs reality.
Core Valuation Methods
Determining business valuation doesn’t rely on one formula. There are several, all of which are appropriate for different circumstances. Let’s look at them:
Income-Based Valuation (EBITDA Multiples)
This method simply applies a multiple to a company’s adjusted EBITDA and is the most used approach in the lower-middle-market. Buyers are getting a future earnings stream, so they want a calculation that reflects how much they are paying per-dollar of those future earnings.
Adjusted EBITDA can account for things such as one-time expenses, personal expenses run through the business, and other costs that do not impact the ongoing earning power of the firm. Buyers want these adjustments to be very well-documented and justifiable.
Market-Based Valuation (Comparables)
Much as a mortgage lender checks what comparably sized nearby homes sold for before extending an offer, business buyers used market comparables. These comps are pulled from transaction databases, reports from the industry at large, and advisor deal histories to gain clarity on what the current market valuation is likely to be.
The more comparables, the more accurate the valuation is likely to be. More data means more real world-feedback and less theoretical modeling. If you’d like a closer look at how this works, this article will help you with understanding valuation techniques in M&A.
Asset-Based Valuations
A calculation focused on assets helps determine the net value of a firm’s tangible and intangible assets mins its liabilities. This approach is used in specific circumstances, mostly in asset-heavy industries such as manufacturing or real estate. It also makes sense if you’re selling a distressed asset with earnings that are either unsteady or non-existent.
If your business has sustainable cash flow, this kind of valuation is more of a value floor than an accurate market pricing framework.
Typical Valuation Ranges
If yourbusiness is in the lower middle market ($500K-$10M in EBITDA) it generally falls between 2.5x and 7x EBITDA. Exactly where you fall within that range depends on a few different things.
Here are some general estimates. These are not hard and fast rules, but guidelines.
- 2.5x-3.5.x are often businesses that are highly dependent on their owners and have issues such as too much client concentration of scaling difficulties.
- 3.5x-5x tend to be good operations with transparent and well-documented financials, reasonable risk and solid growth potential.
- 5x-7x businesses generally have recurring revenue, attractive margins, strong teams and scalable operations.
There are outliers, of course. A small firm with valuable IP and long-term client deals may draw a premium much higher than average for a company its size. Companies with serious issues may also trade below expectations.
Positive Factors Influencing Value
Valuation multiples aren’t pulled from the air but instead reflect a buyer’s cold-eyed assessment of risk and return. If you’re in the low middle market, here are the factors that usually move the needle in a good direction.
- A strongly diversified client base with no one client generating above 10-15% in revenue reduces risk and raises multiples.
- Consistent earnings (up to 5 years of steady or rising EBITDA) telegraphs that a business can thrive in different market conditions.
- A management team that isn’t highly dependent on the owner for operations reduces post-sale risk and helps raise multiples.
- Audited financials and clean reporting boost buyer confidence, helping make the case that no unpleasant surprises may emerge later.
- Buyers love recurring revenue, so long-term agreements, subscriptions and any repeat business will all be highly prized.
- Growth-ready companies with systems and processes that can scale without breaking the bank appeal to buyers.
Negative Factors Influencing Value
The following attributes can ding your value if left unaddressed.
- Spotty financial performance. If you have big swings in revenue or margin, buyers may find such inconsistency troubling and reduce their offer.
- Too much revenue linked to one or a handful of clients creates serious buyer risk that leads to lower offers.
- If the owner (or any key person) is indispensable in the realm of operational knowledge or client relationships, this also creates major transition risk.
- Deferring maintenance too long, neglecting facilities, or not upgrading equipment are all red flags to buyers, who may wonder about your financials or your faith in the business.
- If you have a litigation pending or regulatory/compliance issues, buyers may mark down aggressively.
Getting ahead of these issues is paramount. Step one is reading this article: “Maximizing value: Tips for Selling Your Business.”
What About Timing?
Business valuations are also impacted by larger forces happening in the world. If interest rates, credit availability or the levels of “dry powder” stockpiled by acquirers change, valuations also adjust.
If money is cheap and competition among large pools of buyers exists, multiples rise, and often significantly. If the reverse is true, buyers go “risk-off” and multiples decline.
This doesn’t mean that you should wait for the perfect sell window, as that can lead to the market moving against you. It’s important to get in front of the timing issues by taking an active approach to exit planning. When the time is ripe, you’ll be ready to move quickly.
For more information, please review our article on “waiting too long to sell.”
When to Get a Professional Valuation?
Business owners should seek a professional valuation opinion one-to-three years before exiting. This provides enough time to pinpoint the factors that will lower your multiple and address them.
Getting a valuation closer to your sale period limits your ability to take these steps. By the same token, getting a valuation too early leads to stale market data.
If you’re not quite certain whether selling is right, please check out our “why sell your business” article that explores the best way to make that decision. It will help you factor in your goals, market conditions, and factors such as wealth preservation.
Final Thoughts
Valuation isn’t just a number on paper or a screen. Valuation is a range that is influenced by buyer demand, macro forces, and your own steps to make your business more attractive. The highest multiple are generated by businesses with stable and diversified revenue, strong teams, clean financials, and growth prospects.
Getting in front of these factors early gives business owners an edge when it’s time to sell. After 500+ deals and 25 years in the business, we’ve seen the difference between a reactive seller and a prepared seller can be counted in the millions of dollars.
