Valuation Demystified Part I
Valuation- What’s In A Number?
Valuing a business you've poured your heart into is more than a technical exercise; it's akin to setting a price on a piece of you. Each early morning and late night, every tough decision and leap of faith, has built your business into what it is today. How can one possibly put a price on that? This emotional connection makes business valuation not just a matter of crunching numbers, but also about understanding the story behind those numbers.
While your business may hold immeasurable personal value, the practical side of valuation is important, especially if you're considering a sale, seeking investment, or planning for succession. In this section, we dive into the quantitative basics of valuation, examining key metrics and other considerations.
Private Company Market Segmentation
Before we dive into the quantitative fundamentals that govern valuation, it's helpful to understand the landscape of private companies in the U.S.
The market for private companies in the United States is large. Very … very … large, in fact. By most accounts there are north of 30+ million private companies in the US.
This universe, therefore, encompasses companies of many shapes and sizes. From those with only a single employee, a handful of customers, and thousands of dollars in revenue to those with hundreds of millions of dollars in revenue, a blue-chip customer base, and thousands of employees.
While there is no official categorization for these businesses, industry practitioners (i.e, lawyers, investment bankers, and accountants) organize the market around the segments displayed in the graphic above.
Main Street: These businesses typically generate less than $5 million in revenue and have EBITDA under $1 million, often with fewer than 10 employees. Examples include restaurants, landscaping companies, repair shops, small agencies, and service companies. Buyers include individual investors or those looking for income replacement who will actively work in the business.
Lower Middle Market: Our primary focus at Inkwood. These companies have revenues between $5 million and $50 million, EBITDA from $2 million to $10 million, and employee counts ranging from 10 to 350.
Middle and Upper Middle Market: These segments include companies with revenues from $50 million up to over $1 billion, appealing mainly to larger private equity firms and companies.
At Inkwood we focus exclusively on investing in lower middle market companies. While some of the perspective we offer in the proceeding section will be general in nature, the focus of our commentary we center around the valuation of lower middle market companies.
The Quantitative Basics – EBITDA
Valuing a company often involves several methodologies, such as applying multiples to earnings metrics like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), EBIT, or Seller Discretionary Earnings (SDE), and utilizing approaches like Discounted Cash Flow (DCF).
The common factor in these methods is the use of a "multiple" applied to some key earnings figure of your business. There is no set multiple for a specific business, but you can get an approximation based on what other companies of similar size, industry, and business elements (i.e. leadership, customer dynamic, financial consistency) have transacted for.
EBITDA for better or worse, is the industry standard metric because it offers a snapshot of your company's profitability by focusing on the earnings before accounting for interest, taxes, depreciation, and amortization. Think of EBITDA as a way to measure how well your business is generating cash from its operations, without the noise of tax rates, financing decisions, or large investments in equipment.
Some caveats .... while EBITDA is a useful tool to assess cash flow from business operations, it doesn't tell the whole cash story. To get a full picture of the cash that's truly available in —aka Free Cash Flow (FCF) or Owner’s Earnings —you need to make a couple more subtractions: changes in working capital and capital expenditures (capex). Working capital changes reflect how much money you're tying up in things like inventory or how much cash you're generating from unpaid bills. Capital expenditures are what you spend on buying or maintaining fixed assets, such as property, plants, or equipment. These are cash outflows that EBITDA doesn't account for but are crucial for maintaining and growing your business.
Additionally, when using EBITDA as a basis for valuing a business, it's common to adjust this figure to remove the effects of any one-time events or unique situations that aren't expected to recur, presenting what we call "normalized" EBITDA. This helps potential buyers or investors see a clearer, more sustainable financial performance level.
Understanding how EBITDA and its adjustments impact your company's valuation can be helpful, especially when preparing for financial discussions or potential transactions.
Transitioning from these foundations, we can move to understanding how the size premium impacts valuation in the Lower Middle Market.
The Quantitative Basics - The Size Premium
Businesses with higher EBITDA generally command higher valuations (aka the size premium). This relationship is not merely about larger numbers translating into higher total values; it's largely about how the market perceives the risk and growth potential of enterprises.
A company with $10 million in EBITDA and a 15% EBITDA margin is likely to attract a higher valuation multiple than a company in the same industry with $4 million in EBITDA and the same margin profile. The reason lies in the perceived stability and scalability of larger companies. They can benefit from economies of scale, management depth, operational efficiencies, and typically have easier access to capital markets—attributes that smaller companies often lack.
Lower Middle Market EBITDA Thresholds
In the traditional private equity model, investment decisions often hinge on reaching certain EBITDA thresholds that categorize businesses within specific market segments
$2 million EBITDA: Often viewed as the entry point to the lower-middle market by conventional buyers such as PE firms. Businesses at this level are typically targeted for add-on acquisitions to complement existing platforms but rarely as standalone investments
$5 million EBITDA: This threshold is where many lower-middle market private equity firms begin to take serious interest, viewing companies as ripe for investment, particularly for serving as platforms for industry consolidation. The higher end of this EBITDA gate ($7 million +) is seen as a sweet spot for a platform company in many PE strategies.
$10 million EBITDA: Companies reaching this milestone see a significant increase in potential buyer interest, crossing into territories favored for major strategic acquisitions or flagship investments in a PE portfolio
How Inkwood Values Companies
Inkwood values companies based on our investment approach. In other words, our valuations are based on the company's ability to operate indefinitely and generate earnings, rather than profiting from flipping the company to another buyer. This translates into our valuations generally being based on a multiple of owner earnings.
Owner earnings represent the cash available to the owner after all expenses, including things like necessary capital expenditures, have been paid. We apply a multiple to the owner earnings based on the durability, stability, and potential of the business.
Whether we value a company at the low or high end of a “market range” (or, occasionally outside of it), is determined by the situational factors of the particular business. For instance, a volatile financial history traditionally will earn a lower multiple, while a company with capable management in place will earn a higher multiple. While the math itself is not hard, the context is important; this is why we tend to ask lots of questions before offering our valuation.
Wrapping It Up
As we've explored the complexities of valuing a business, from the tangible metrics of EBITDA and size premiums to the more subjective elements like market perception and operational efficiency, it’s clear that valuation is as much an art as it is a science. Your business is more than just numbers on a spreadsheet—it’s a living, breathing entity shaped by your vision, effort, and leadership.
If this discussion has sparked questions or if you’re seeking more personalized insights, reach out to us!
