I recently had coffee with a business owner who has built a successful advertising agency. He has grown his business each of the last three years to the point where this year he expects to generate $1,000,000 in pre-tax profit on $6,000,000 in revenue.
Such success can often come from a kind of single-mindedness. Indeed, the server hadn't even taken our coffee order before the business owner got down to the reason for our meeting:
'What do you think my business is worth?'
His eagerness was understandable, but valuation is a complex game. I pushed him to tell me what he thought his company could garner. He had heard that marketing services businesses were going for between 'four and five times,' by which he meant four to five times earnings before interest, taxes, depreciation and amortization (EBITDA).
But even after determining that we were talking about EBITDA, the basic question of "Four to five times what?" remained. Most business owners focus on the multiplier and spend less time on what they are multiplying. Some buyers will calculate their valuation by applying a multiple to the reported pre-tax earnings for your last complete year. Others will take an average of your last three years' earnings. Another way is to use the current year's expected earnings.
Buyers will consider future projected profits, but often only when it suits their needs. Professional buyers will try to justify their offer to you using historical earnings while they rationalize the price to their board using your future expected earnings.
Each methodology can have a big impact on the price you get for your business. Let's say you're halfway through your fiscal year and on track to hit $800,000 in pre-tax profit this year. The last three years you did $500,000, $300,000, $250,000, respectively. Using a blended average of your historical profit over the last three years and applying a five-times multiple, your business is worth $1,750,000. Using this year's expected earnings, and applying the same five-times multiple, your value is $4,000,000—more than double.
To get prospective buyers to run a valuation based on your current year's earnings, show them that they can take your expectations for this year to the bank. Here are some tips to pull that trick off:
In addition to the list above, there is one small change I would recommend as you talk and write about your business' financials: stop referring to this year's numbers as 'projected' and start describing them as 'current year'. You can easily make this change to the PowerPoint and Excel documents you use to describe your business plan. It may seem like nitpicking, but characterizing your financial results and expectations as 'current year' sends an important message to a potential buyer: your projections are solid and not some wild-eyed fantasy you made up on a napkin.
John Warrillow is the author of Built to Sell: Turn Your Business into One You Can Sell. He has started and exited four companies. Most recently John transformed Warrillow & Co. from a boutique consultancy into a recurring revenue model subscription business, which was acquired by The Corporate Executive Board. In 2008 he was recognized by BtoB Magazine's 'Who's Who' list as one of America's most influential business-to-business marketers.