In topic 28 we fully discussed Seller Discretionary Earnings (SDE) calculations and strategy.
The final SDE amount becomes the predicate for the business valuation.
The second component of the computation is the earnings “multiple”. It is usually a single digit number, but it is the most important number out of all numbers involved in the transaction because of its economic impact.
Example – company with 5,000,000 of SDE earnings
- 5,000,000 X 3 = 15,000,000
- 5,000,000 X 4 = 20,000,000 33% Higher
- 5,000,000 X 5 = 25,000,000 67% Higher
- 5,000,000 x 6 = 30,000,000 100% Higher
For some unknown reason most offers come in with a single digit multiple such as 5 instead of a multi-digit number such as 4.375 even though that decimal point difference changes the price by 3,125,000.
There are all kinds of industry data sources that provide guidelines on multiple ranges per sector and subsector. Buyers will regularly point to these sources to legitimize their offers.
In reality no two companies are identical and each and every valuation is unique.
Example 1. We discussed previously that two 500 employee companies are identical except one company’s average employee retention is 8 years and the other is 15 months. The learning curve, experience and employee loyalty make the company with the 8-year average more valuable. It should be more valuable because ownership clearly respects and retains their employees.
Example 2 - two 20,000,000 excavation companies. Everything is identical except one company has 5,000,000 of paid for equipment and the other leases all of their equipment.
You can quickly see that the same multiple for each company would be inappropriate.
It was stated in the very beginning that every aspect of an M&A transaction is a negotiation.
The defining of the multiple is at the apex of negotiating importance.
At the end of the day, it is not about the remedial math. It is about the business value that is achieved from the math.
The is where the burden is on the M&A advisor to convincingly represent the value of the company and to generate a significant amount of market interest and bidding.