Even prior to the popularity of ABC’s Shark Tank, entrepreneurs and investors have been at odds with regards to finding a fair valuation on a business. Often the entrepreneur sees the company as his/her baby and investors look at such quantitative factors as earnings, market share and industry data. Basically, the investor is looking to get as much capital as possible – putting him or her squarely at odds with the equity investors who want to fork over as little as they can.
Reality shows aside, there are other reasons an entrepreneur may want to have their business evaluated. General curiosity, for one. Just like an employee floating out a resume to test the water, it’s not a bad idea to know what your company is worth. Then there’s estate planning or in the event of a divorce or dissolution of a partnership.
Andrew Sherman, a partner at legal firm Jones Day and author of over a dozen books on the legal and strategic aspects of business growth and financing, including Raising Capital: Get the Money You Need to Grow Your Business suggests entrepreneurs understand the things investors look for prior to making a fair value determination.
EBITDA. Short for earnings before interest, taxes, depreciation and amortization, EBITDA is a commonly used profitability gauge and provides insight into how much profit a company earns with its current assets and its operations on the products or services it sells. “What you’re trying to get to there is a raw earnings number,” says Sherman.
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Multipliers. When a business is being evaluated, a multiplier of that EBITDA number is used as a barometer. That multiple is determined by the overall health of the industry the company competes in. For example, if the company has EBIDTA of $1 million and in an industry where similar companies are selling at a 5X-7X multiple, in theory that company is worth about $5 to $7 million.
“Every business owner should be finding out the multiple ranges these days, given market conditions and given the industry,” Sherman advises. “If you’re in a really hot industry, your multiple range could be as high as eight to 10 times EBITDA. If you’re in an industry that’s dying a slow death, the multiple range could be an unimpressive 2X-3X EBITDA. That’s a big difference.”
Qualitative vs. Quantitative. EBITDA and multipliers are all quantitative measures used by investors and business evaluators. But if a company, such as a developer of a cancer treatment is in the final state of FDA trials, has no earnings or revenues, it doesn’t lend itself to these calculations. However, the product has enormous potential.
“I have something that I use in my speeches on this topic called DCBMU syndrome – don’t call my baby ugly syndrome,” says Sherman. “That’s the classic entrepreneur defensiveness that says ‘hey, I know there’s flaws in my company, but I either have a blind spot to addressing them or my ego won’t let me admit them.’”
Finally, Sherman advises not to get caught up in the headlines surrounding things like the social media app du jour selling for billions of dollars.
“I’ll sit with clients, and say ‘look, I know that WhatsApp just sold for $19.5 billion, but here’s where your company is a little different. You don’t have 500 million users as an example,” he says. ”You’re not a future threat to Facebook so they decided to overpay for you. There are a lot of nonfinancial variables that go into the mix. It’s like two levers. If we have both the quantitative lever and a qualitative lever, both could be used to benefit you, your valuation, or hurt your valuation.”