Skip to main content

When it comes to selling a house all homeowners think it’s worth more than it really is. Yet a 4,000 square foot house on an acre lot surrounded by similar houses is going to be worth more than a similar house built on a small, teardown lot that has 60-year-old 1,500 square foot ramblers surrounding it.  Yet when homeowners see the former house sell for a certain price they think their house, the latter example, is worth the same.

The same is true with small businesses when it comes time to sell. I wrote last year about the pricing of middle-market companies and an article in the Zachary Scott newsletter titled “8 is the new 6” (referring to multiples of EBITDA on middle-market deals). I’m seeing more and more owners of small businesses ($3-10 million or so in sales) thinking their company is going to be priced the same as a $50-100 million firm.

Now what adds some sanity to this are the banks. They are not investors so they won’t let prices to be bid up too much (more on this later).

Sellers must be perusing the Internet and getting their heads filled with info on larger deals. It’s always been a good story to say when an owner sees in the Wall Street Journal that a $400 million company in their industry sells for 9X EBITDA and expects their small business will also sell for 9X EBITDA (it won’t). Or perhaps they figure the prices for business have skyrocketed like the stock market.

In the last few weeks owners (of companies doing $3-10 million in sales. or less) have said to me:

  • I heard my business is worth 5-7X EBITDA.
  • I expect to sell my business for 6X total cash flow (profit or EBITDA plus owner salary).
  • I want to sell for one times annual revenue (98% of the time revenue and price are completely unrelated).

Some real life examples of businesses my clients have seen include:

  • A highly technical service business requiring the owner to do much of the technical work, the asking price is about 7X profit (after a modest owner salary).
  • A firm with volatile sales, low earnings and an owner who thinks he should get one times revenue.
  • A seller who wants to sell, take the money and keep the job (and very high salary) of running the business.
  • The owner of a business whose sales have been declining for four years and while it’s still profitable he won’t share any information until a buyer shows him he can pay the asking price all in cash (now how is a bank going to make a decision without seeing financial information?).

A small glitch to a $100 million business (a machine breaks) could be a catastrophe to a $5 million business. One key employee leaving out of 500 total employees won’t matter. One key employee out of 25 could have a huge impact. These are just a couple of the reasons for the pricing differences.

And speaking of banks, back to our sanity test. Banks are in business to be paid back and they have certain rules they must follow. Of prime importance to a buyer or seller is the debt coverage ratio. Most banks minimum is 1.25:1 (meaning $125 of profit for every $100 of loan payments). Good bankers won’t go near the 1.25:1 ratio. They’ll want a ratio of at least 1.5:1 (and I say the smaller the deal the higher the ratio should be).

One similarity between the sale of a house and small business – the neighborhood matters. As with my above example, the price of the house is influenced by the houses nearby. The general pricing for businesses of the same size and type influences the price of a small business. The price is not influenced by the pricing of businesses 5-50 times larger.

Get Started With A Consult

This field is for validation purposes and should be left unchanged.