This is a brief guide to business valuations for the lower middle market. For a more complete guide please obtain the Valuation Guide using the form.
The diagram below is a Compass Point variation on the “rules-of-thumb” valuation metric for lower middle market businesses (businesses with earnings between around $500K and $20 million). The very basic and rough rule of thumb valuation for a company with around a million or more in earnings is a value of 5 times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Why five? Because the average selling price for many businesses turns out to be 5x EBITDA (lower for companies under one million in earnings). Do middle market buyers really just use a multiple of five when buying a business? No, they will perform extensive analysis and run financial models for every deal. However after all the analysis and models, some deals end up below five, some above, and the average has remained around five.
Which brings us to the valuation chart. Why are some deals more than 5x, and some less? Here’s the guide:
What the chart says is this:
The 5x base value assumes the company has a stable history of performance and has no significant blemishes. A stable financial performance is the most basic component, the foundation of a valuation.
EBITDA can be enhanced by a buyer that can reduce costs and take advantage of other synergies, and because of that the synergistic buyer can afford to pay a little more for the company. They will not want to, of course, but with a competitive situation and negotiation they usually will.
A strategic buyer that can go further and take the company to a new level of sales growth and open up new opportunities (usually as well as the cost synergies, above) can afford to pay even more. Note that it still comes down to financial performance and earnings, but the strategic buyer is betting they can pay now for later earnings. Unfortunately, the true strategic buyer that will pay a substantial premium is somewhat rare.
However, nothing’s perfect and I’ve yet to run across the perfect company. There are always blemishes, and if serious enough to cause a risk that future earnings may not actually turn out as expected, then these blemishes work to pull down the valuation. Do you have one customer (or supplier) that contribute more than 25% of your revenue? Messy financials? Lots of adjustments (addbacks) to the earning? These can pull that 5x multiple down to a 3x. Or if you have a strategic buyer, perhaps they’ll only pay a 5x.
A professional valuation uses a similar process to the guide by taking a close look at your fundamental performance (e.g. discounted cash flow approach to valuation) and/or looking at whether your particular market has a history of strategic buyers (e.g. the market approach to valuation), and then they discount the value based on the some of the risk factors they find.
If you can stand back and take an objective look at your business, you should be able to estimate a multiple for your business.
FAQs
Lower middle market refers to the lower end of the economy's middle market segment, which is measured in terms of the firms' annual revenue. Firms that are grouped under the lower middle market category realize an annual revenue that ranges from $5 million to $50 million.
How do you calculate valuation of a small business? ›
Add up the value of everything the business owns, including all equipment and inventory. Subtract any debts or liabilities. The value of the business's balance sheet is at least a starting point for determining the business's worth. But the business is probably worth a lot more than its net assets.
How much is a business worth with $1 million in sales? ›
The exact value of a business with $1 million in sales would depend on the profitability of the business and its assets. Generally, a business is worth anywhere from one to five times its annual sales. So, in this case, the business would be worth between $1 million and $5 million.
What is the rule of thumb for valuing a business? ›
Discretionary Earnings Rule of Thumb
The discretionary earnings method starts with the annual cash from the business that's available to the owner after taking out essential operating expenses. It then multiplies that number by a factor usually between two and four, depending on the business type.
What is the lower middle market EBITDA range? ›
EBITDA=$5,000,000 to $10,000,000
By definition, this level of EBITDA could be truly deemed “the middle market.” Most would consider anything below the $10M EBITDA size range as “lower” middle-market. Once a company reaches this range of EBITDA, the multiples paid increase yet again.
How do you value a medium sized business? ›
Professional valuators typically use a mix of three methods to confirm the value of a business.
- Income-based approach—calculating a multiple of EBITDA.
- Assets-based approach—calculating the value of tangible and intangible assets.
- Market-based approach—checking what comparable companies sold for.
Businesses can be worth two or three times the annual profit. However, to find your business worth or value, you can use a Price to Earnings P/E valuation: P/E ratio = valuation. Previous How do you price a small business?
What is the most common way to value a small business? ›
Small businesses are commonly valued by their price-to-earnings ratio (P/E), or multiples of profit. The P/E ratio is best suited to companies with an established track record of annual earnings.
What multiples do businesses sell for? ›
The following are some common valuation multiples for small businesses:
- Retail: 0.5 – 1.5 times EBITDA.
- Restaurants: 0.5 – 2.0 times EBITDA.
- Manufacturing: 0.5 – 3.0 times EBITDA.
- Service businesses: 1.0 – 4.0 times EBITDA.
- Software-as-a-service: 4.0 – 8.0 times EBITDA.
Factors Affecting Small Business Valuation
Thus, buyers have to approach the deal as if they are purchasing a job. Businesses where the owner is actively-involved typically sell for 2-3 times the annual earnings of the company. A business that earns $100,000 per year should sell for $200,000-$300,000.
Businesses are often valued using a “multiples approach,” where a dollar amount representing income is multiplied by certain whole numbers or fractions. A common multiples approach is known as the “times-revenue” method.
How many companies reach $10 million in revenue? ›
Fewer than five percent of all businesses in the US grow to be more than $1 million in annual revenues. And fewer than one percent make it to $10 million.
What is the Big 3 rule of business? ›
Ultimately, the Rule of Three is about the search for the highest level of operating efficiency in a competitive market. Industries with four or more major players, as well as those with two or fewer, tend to be less efficient than those with three major players.
What are the four basic ways of valuing a business? ›
4 Most Common Business Valuation Methods
- Discounted Cash Flow (DCF) Analysis.
- Multiples Method.
- Market Valuation.
- Comparable Transactions Method.
Three main types of valuation methods are commonly used for establishing the economic value of businesses: market, cost, and income; each method has advantages and drawbacks.
What fund size is lower middle market? ›
Lower middle market PE firms typically invest in companies valued between $10 million and $100 million.
What is a lower middle market fund? ›
There is a lower-middle market, often defined as companies valued at as low as $10 million. Typically, large-cap private equity deals are $1 billion and above. The middle market represents two-thirds of total US PE deal value.
What does lower valuation mean? ›
A low valuation means that the company is early-stage and has high potential for growth. This is an attractive proposition for investors, as they stand to make a higher return on their investment if the company is successful.
What's below lower middle market? ›
Because of the wide range of company sizes within the definition, the middle market can be further broken down into the following: Main Street- <$5 million of revenues. Lower Middle Market – $5 – $50 million of revenue. Middle Market – $50 – $500 million of revenue. Upper Middle Market – $500 – $1 billion of revenue.
