The scope of this article is limited to business valuation for the purpose of selling a company and does not include valuation for other purposes such as litigation, insurance, liquidation etc.
When practicing my profession as a business broker in the Greater Toronto Area, the most frequent question I am asked is “how much is the business worth?”. While most are not ready to pay for a formal business valuation, both business buyers and sellers are extremely interested to know the value of the business they are trying to sell and buy. While business valuation articles I have written before are very general, this one is more specific and describes most commonly used valuation methodologies used in Toronto and surrounding areas in Ontario for the purpose of selling or buying a business. Below are some of the most commonly used methods:
This method is mostly used for valuing middle market companies (values higher than one million dollars). Accountants, Mergers and Acquisitions Intermediaries and Middle Market Business Brokers. it consists of computing EBITDA (Earning Before Tax, Depreciation and Amortization) and applying a multiple to arrive at the Enterprise Value. The enterprise value is then reduced by the amount of interest bearing debt to arrive at the value of equity. This value included equipment, goodwill, inventory, accounts receivable and the necessary cash to arrive at a historical average of working capital. The computed EBITDA has to be normalized before applying the multiple. The normalization process involved the non exhaustive list below :
- Adjusting the seller’s and his family members’ salary to market salary. Not working family salaries should be added back to EBITDA,
- Adding depreciation and amortization
- Subtracting the capital investment costs for the following year necessary to maintain the sales at their current level.
- Adding back to profits any one time, non recurring costs such as a large bad debt resulting from a large client bankruptcy.
- Adding seller’s personal expenses and perks not necessary for the operation of the business such as meals and entertainment, if not necessary for the business, car allowance, personal insurance etc.
- Adjusting rent to market price if the owners owns also the real estate or rents at below market rent that cannot be transferred to the buyer.
The multiple of EBITDA used for valuation is determined from comparable transactions in similar industries. this is the most challenging step since private company transaction information are generally not available to the public. Some business for sale websites offer incentives to business brokers to collect pricing information for closed transactions and offer large databases of transaction to business valuators for fee based subscriptions. These large databases are not always reliable since business transactions have so many terms other than price that are generally interrelated and influence price, and terminology used by these websites do not always have standard meanings to all business brokers.
Transactions in the Greater Toronto Area are not necessarily comparable to transactions in other US cities mostly because of the difference between Canada and the US in currency, risk, tax rates etc. EBITDA multiples in Toronto vary between 3 and 5 with 4 been an average especially in challenging economic times. These multiples can reach 7 in good times for established companies. High growth companies especially in the technology sector can reach much higher multiples, especially for a strategic buyer.
Seller Discretionary Earnings (SDE)
This method is mostly used for small businesses with less than one million dollars in value. This method is very similar to EBITDA with two main differences:
- The salary of the owner is added to SDE and the same normalization process is applied
- Inventory, Accounts receivable and cash are not included in the valuation.
Multiples of SDE are much lower than those of EBITDA. Generally between 1 and 3 in Toronto. Larger companies tend to sell for larger multiples. Multiples are lower for companies with problems, high risk or who require a large amount of inventory and accounts receivable.
Asset Based Valuation:
This method is generally used when the EBITDA or SDE methods cannot be used, especially when companies are unprofitable or when profits are very low compared to the value of assets. This method is generally the calculation of the net book value of the company. Most buyers acquiring a company based on the method are turnaround buyers with clear plans to make dramatic changes to the acquired companies to improve the bottom line.
While valuation is an important step before listing a business for sale, sellers should understand the the sale price will be the price a buyer is willing to pay irrespective of what a formal valuation is. A strategic seller for example can pay much more than the company valuation.