There is a lot of chatter in the IT community about exit strategies, M&A, and business valuations involving earnings before interest, tax, depreciation, and amortization — and they’re important discussions.
Selling, transferring, or closing your business is a very personal decision. It is the business equivalent of sending your grown child into the world to live on his own. Your business is an extension of you and your entire existence for as long as you’ve owned it. It fed you, housed your family, and provided education for your children. This takes careful planning, execution, and soul-searching.
Asking Price And Valuation
The natural starting point for an exit series is to discuss valuing your business. You will hear a number of theories as to what your business is worth, buy which valuation method is the correct one? The answer is, “All of them.” Any business valuation company worth the size of their invoice will use a minimum of three valuation methods and take an average to determine the overall value of the business. Even this is not an exact science all the time.
You spent your life building this business from the ground up. Your company’s equity is filled with blood and sweat from the many times you ate hot dogs and beans so your employees could get paid. It may also be your retirement plan, and you want proper compensation. Unfortunately, blood and sweat don’t appear on a balance sheet unless you get a paper cut after printing it in your office with the broken air conditioner. The buyer is going to look only at the tangible value of the business. If you are truly ready to sell or exit your business, you must first remove the emotional factor from the asking price.
Step back and look objectively at your business. How much would you pay for a business that looked just like yours? If you have a solid number in your head of what you think your business is worth, spell it out on paper why the company is worth that exact number. Create a document outlining your company’s specialties, your vertical industries, and how you are better than other IT firms in your market. What makes you stand out? Does your business run because you run it, or can it run on its own power? Do you own a job or do you own a business?
Valuation Based On Profit
There are multiple ways to value a service company. One of the most popular ways is profit times a multiple. Profit is also known as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and that multiple is often four, but can vary. EBITDA can be pulled from your income statement and adjusted for owner benefit items and normalization of expenses.
If you normalize your expenses prior to listing your company for sale, you will save yourself a lot of heartache. You may have annual revenue of $500,000 and run a P&L from your accounting system and see a $225,000 net profit. If you do not have salaries or rent expense listed, do not think you are getting $1 million for your business. This is not a normalized business financial. You may be running the business from your home and have no overhead expenses, but that does not increase your business value.
Your business figures must be brought into conformity with the normal IT business of your size. You may decide not to use a remote management tool and, instead, do all remote work with remote desktop. Or perhaps you choose to use a free antivirus on all client computers. A buyer likely will not be willing to maintain these procedures, so those accounts will have costs associated with them and need to be normalized to understand the value of each account. The same theory applies with overhead expenses such as rent, utilities, and staffing.
Valuation Based On Future Profit And Asset Value
Another form of valuation is based on the expectation of future profit. This doesn’t happen often because no one has a crystal ball. However, it does happen when the buyer wants your business because it complements the business they already have and your EBITDA numbers are not high enough to make the offer attractive. This type of sale usually results in an amount held in escrow in anticipation of future earnings. If revenue and income goals are met, the escrow money is released to the seller at some date in the future.
This is the riskiest form of valuation for both parties. When EBITDA is low, the buyer will often require heavier net assets to make the deal. This is also known as an asset-based valuation. When presented with an offer based on this valuation, the buyer may require that assets meet a certain figure, and any liabilities will be net of those assets.
For instance, your balance sheet may have $100,000 in the bank accounts, $150,000 in accounts receivable, $50,000 in inventory, and $75,000 in fixed assets for a total asset value of $375,000. If the required net asset to the buyer is $350,000, this sounds like you have it covered. However, if you have accounts payable of $30,000 and loans totaling $80,000, the buyer will not take on those debts because it will fall under their desired net asset value. With $25,000 of space between your assets and the required figure, you can transfer most of your accounts payable to the seller, but the additional $5,000 and the full $80,000 will come from your sale proceeds. All of a sudden, you are receiving $85,000 less than you expected for your company.
If you need to sell your business fast, and you think you’re getting a great deal, think again. This offer is the seller’s way of making a lowball offer sound great, but the devil is in the details.
Valuation Based On Gross Revenue
Some revenue holds greater value for a company than other revenue. Product sales in an IT firm are intermittent unless you regularly cycle client equipment. Break/fix work requires something to break before you have work. These two revenue streams, while they may seem consistent, hold less value than recurring revenue on a contract. A buyer can feel confident that the customer will stay for some set period of time. It’s up to the buyer to keep the customer happy and not make sales calls.
Almost no revenue is dollar-for-dollar in value. All revenue comes with some form of cost and risk of drop-off in a transition. However, buyers may be willing to pay between 80 to 90 percent of contracted recurring revenue, while only offering 30 percent of products and 40 percent of time and materials work. T&M work values may increase if it is tied to a recurring revenue contract such as Business Hours Unlimited Remote Support.
Finally, you may also see valuations based on a multiplier of Gross Profits or comparative market values. There are many widely accepted methods to valuing a business. I have presented you with only three of the most popular. Many accounting firms and professionals can help with your business valuation. Please be sure to consult with them for an accurate picture of your company prior to listing it for sale.