High School Math, Pizza, and The Big Multiple, aka, The Holy Grail For Business Owners

The age old question of the Multiple. What helps? What hurts? Pay attention! And gee whiz, I hope you all like algebra.

By Bill Snow

Algebra. There, I said it. Understanding how to value a business ultimately comes down to an algebraic formula. I know, I know, some of you probably hated math. Here’s a dirty secret about yours truly…I loved math. Usually set the curve in each class I took. I never studied, I simply showed up for class, did the homework, and aced every exam. Came naturally to me. Straight A’s, baby! I then applied the same techniques to all my other subjects with, uh, somewhat varied results.

Of all those math classes I aced, I particularly liked the most useless of the math classes, geometry. I say “useless” because that’s essentially how our teacher introduced the subject to us. “You’ll never use this stuff,” so said our teacher, “but you need to learn it.” Most kids immediately zoned out. I thought, “cool, useless info, someday I’ll write a newsletter and make mention of this!”

That teacher, and I suppose many other geometry instructors who employ the same “you won’t use this but pay attention” approach, inadvertently do their students a disservice. In just a few years when those students go off to college they’ll be in desperate straits as they try to figure out how much pizza they need to order. Not enough, and students starve. Too much, and their feeble finances are strained.

If only high school teachers stressed the importance of A=PiR2 (area equals Pi r squared, in case these symbols got jumbled in transmission), hapless and pizza deprived college students would be able to order an accurate amount of pizza because they would know how to calculate the area of a circle. Well, assuming they know how much pizza each student wants.

Since some of those pizza noshing college students end up becoming business owners, high school algebra does them a disservice, too. High school algebra is important because it inures the lifelong learner to the use of parentheses and brackets and all manner of squiggly lines. And if you can at least grasp some of the basics of algebra, you have a chance to understand the intricacies of business valuations. I just know if high school teachers told their young charges, “listen up, you whiny brats, this is important stuff, you’ll need to understand it when you’re all grown up and doing business deals,” those teenagers would pay better attention. Yup, no doubt. That’ll make the kids pay attention.

So why is algebra important to business deals? It’s important because it factors into the Holy Grail for all business sellers: The Big Multiple. And why is the Big Multiple important? Because it allows the seller to brag about the Big Multiple to other people!

And that’s not a complaint. Who doesn’t want to be rewarded for years of hard work and risk taking? Who doesn’t want to extract the best possible price and unlock latent value? Who doesn’t want to be able to actualize their creative abilities?

For most business owners, valuation is a product of a multiple of earnings (usually EBITDA). That multiple is often in the range of 4X to 6X EBITDA, with — surprise surprise – 5X being the kinda sorta hoped for de facto multiple. So the algebraic formula looks like this…

[range of multiples] X EBITDA = valuation 

However, that is a simplistic view of valuation. First, sellers should use an “adjusted” EBITDA calculation, that is to say, EBITDA adjusted for any expense that would go away post sale. These can include outsized salary and bonus as well as sundry personal expenses. Usually, adjusted EBITDA is larger than EBTIDA.

Second, the total deal value should be viewed not only in terms of the multiple of adjusted EBITDA, but instead, owners should add to the valuation any cash in the business, subtract any debt that needs to be paid off, and make an adjustment for working capital. So now, our formula looks like this…

{[range of multiples] X adjusted EBITDA} +cash -debt +/- working capital adjustment = valuation

See how quickly those brackets and squiggly lines start to multiply? Now here is where a love of algebra comes in handy. That range of multiples that I’ve mentioned can be affected, positively or negatively, by a whole slew of enhancers and detractors. So now our formula looks like this…

{[range of multiples + enhancers – detractors] X adjusted EBITDA} + cash – debt +/- working capital adjustment = valuation

So, what are some of these enhancers and detractors to value?

Enhancers can include the following:

  • A rapidly growing company in an expanding market
  • Strong (and long) customer relationships
  • An experienced management team with a strong track record
  • The quality of vendor relationships
  • Disciplined and well run distribution channels
  • Non-competes in place with the sales force
  • Unique expertise (e.g., sales approach or marketing skill)
  • Use of technology (is it leading edge, up-to-date?)
  • Intellectual property (patents, licenses, trademarks)
  • Physical condition of business – are facilities and equipment well maintained, clean, and in good shape?

Detractors can include:

  • Competing in a market that is in decline or out of favor
  • Customer concentrations
  • Customers with financial weakness
  • Senior staff with little or no reason to stay post-acquisition
  • Absence of non-competes from key sales staff
  • Poor labor/union relations
  • Unkempt/Deteriorating facilities and equipment

What can owners do about it?

Quite simply and obviously, tout the strengths and fix the weaknesses. Granted, that can be easier said than done, especially with some of the detractors. Cleaning up a messy facility and repairing equipment is straight forward and simple. Getting existing staff to suddenly sign non-competes can be fraught with risk, especially if an owner is not offering anything in return.

Customer concentration issues and problems with financially weak customers can be addressed by actively (if not aggressively) seeking new customers. Poor labor relations can only be remedied over time. Maybe.

Businesses competing in declining markets can face a particular difficult challenge. If the market is in decline an owner can either quickly try to affect a transaction and accept a low valuation (get out while the gettin’s good, so to speak), or, if the owner is willing to invest time and money, that owner may want to expand into new markets, and perhaps even introduce new products.

If senior management at a company is getting close to retirement age, an owner will be wise to begin succession planning before starting an M&A process. This might involve bringing in younger talent or developing existing managers to replace the soon-to-be retiring senior managers.

Owners should be objective in their analysis and understand if their company has a number of detractors the ability to increase the multiple will be diminished. However, with suitable time and planning, an owner may be able to minimize detractors and help improve the ability to generate a strong valuation. For owners with businesses with substantial detractors, the time to address those detractors is long before they decide to sell the business.

Lastly, owners are advised to avoid getting caught up in seeking a certain multiple simply because it is a certain number. Instead, owners should focus on putting together a deal that makes sense. While a high multiple is always a desirable result, chasing an unreasonable high valuation at the expense of doing a perfectly acceptable deal makes little sense.

As I always suggest, owners should speak with their financial advisers about their long term planning. They just may find a deal with (what they think is) a low multiple may be perfectly suitable for their needs. Now, if only I can remember which high school math class provided the formula for that!

A big assist goes to Bob Kinsella who provided much of the initial thoughts about enhancers and detractors