Business buyers and sellers often enter negotiations with a price in mind based on a “multiple” of some measure of historical revenues or profits. Although these multiples appear to be simple, they reflect complex financial, operational, marketing and legal conditions internal to the business. They also reflect economic, industry and capital market conditions external to the business.
Since buyers and sellers have different impressions regarding these conditions, their multiples are usually different. The more the parties know about what goes into their multiple — and the range of multiples that may apply to a company — the better positioned they are for negotiation.
Multiples reflect the expected timing and amount of future cash flows a business will generate. Cash flows received by investors may vary depending on whether the transaction is structured as an asset or equity sale. Also, since reasonable minds can differ regarding the extent to which these cash flows will be affected by conditions internal and external to the company, buyers and sellers will frequently have different expectations.
When buyers don’t have unique ways to increase the value of the business after the sale, their multiple will reflect the fair market value of the company. Fair market value is the price at which the business would change hands between willing and able buyers and sellers where neither is forced to transact and both have reasonable knowledge of the relevant facts. Fair market value is typically considered a price “floor.”
But when a particular buyer has unique synergies or ways to increase the value of the business after the sale, his or her multiple may be higher, reflecting the investment value to that specific buyer. Investment value is often considered the price “ceiling” for a transaction.
How Much Risk?
Since value is based on expected returns, the multiple must reflect the risk or uncertainty regarding the timing and amount of these returns. Again, reasonable minds can differ regarding the extent to which internal and external conditions will affect this uncertainty.
Businesses with established products and customers are often perceived as less risky than businesses without them. Lower risk would be reflected in a higher multiple. However, businesses without established products or customers are frequently attractive investments due to their significant growth potential. That growth potential sometimes drives multiples up more than the absence of established products or customers drives it down.
Also, when the market is booming and both debt and equity capital are plentiful, investors may be less risk averse and, therefore, willing to use a higher multiple and pay a higher price. Conversely, if investors see trouble ahead, they may become more risk averse. This may cause debt and equity capital to become more scarce, multiples to contract and prices to decline.
Calculating a Multiple
Valuations provide several ways to boil these conditions down to a multiple. One way, the “income approach,” calculates the multiple by reference to similarly sized publicly held companies adjusted for differences in risk compared to the company for sale. Another way, referred to as the “guideline public company” method, calculates the multiple by reference to publicly held companies with similar risks adjusted for differences in size compared to the company. A third way, referred to as the “comparable company transactions method,” calculates the multiple by reference to transactions of companies similar to the company in terms of both size and risk.
The strength of the income approach and guideline public company method is the abundance of available data. However, this strength is tempered by the sensitivity of these analyses to adjustments, which are subjective. The comparable company transactions method has the potential to minimize the effect of these subjective adjustments, but it is often undercut by the presence of a very limited amount of data.
The multiples used to determine the value of a company depend on all of these factors, and multiples are just one piece of the price. A successful outcome is more likely if each party enters negotiations open to a range of potential multiples. A valuation analyst can help the parties understand pricing multiples by explaining how complex internal and external conditions affect the expected cash flows and risk of a business.
Thinking about buying or selling a business? Our valuation analysts can help you prepare for your negotiation.