Last Updated Jul 29, 2010 3:51 PM EDT
Let me explain.
I used to own a five-person advertising agency. I did the selling, and my employees did the work. We squeezed out $150,000 in pre-tax profit from $750,000 in revenue designing brochures and websites.
Curious to see what my business might be worth, I started to investigate how advertising agencies were being valued. I found at the time they were trading for 18 to 22 times earnings before interest, taxes, depreciation and amortization (EBITDA) by the stock market. I did the math and figured, using the 18- to 22-times multiple, my $150,000 in pre-tax profit could equate to a business worth $3 million or more.
Excited by the prospect of a multi-million dollar payday, I asked around at our industry trade show and heard that small marketing agencies were selling for about four times pre-tax profit. I was disappointed to learn smaller agencies sold at such a steep discount but was still relatively happy to know that my little five-person shop was worth more than half a million dollars.
In fact, I started to think of the $600,000 my agency was worth (using a four-times multiple) as if it were a relatively liquid asset like my home or mutual funds investments.
I remember well the meeting that finally burst my bubble. I was sitting at a boardroom table across from two partners in a 60-employee advertising business that generated around $10 million in sales. I was pitching the partners on investing a little cash and expertise in my company.
I had prepared for the meeting with PowerPoint slides describing the future I saw for my agency. I had projections, spreadsheets -- I was prepared for their questions. As I got ready to ask them to invest, one of the partners interrupted: "We wouldn't buy equity in your business at any price. Your business is really not worth anything right now."
I felt as if I'd been sucker-punched. I could feel the irritation rising up inside of me, and the adrenaline pushed away any opportunity for rational thought.
Angry now, I responded, with as much authority as I could muster, "Small agencies sell for four to five times. My business is worth at least $600,000."
"Well, it's not worth that to us."
The problem? In short, me. What I would later learn is that acquirers place a steep discount, often to zero, on very small businesses in which the owner is doing most of the selling. In the absence of any more objective measure, acquirers often do a quick valuation test by looking at the size of the company and how involved the owner is in the selling. By doing all of the selling, I was actually bringing the value of my company down. Acquirers reason that a very small business is probably highly dependent on the owner, whereas a larger business got big by figuring out how to get other people to do much of the selling.
How do you avoid this small-company discount to zero? It depends on the buyer. Some acquirers look for a company with at least $5 million in sales; others look for at least $1 million in earnings before tax; others have no hard number but use soft measures to see how dependent the revenue is on the owner personally.
After recovering from that fateful meeting, I focused on hiring salespeople so that we would grow larger and I could legitimately make a case that other people were doing the selling.
For Sale photo courtesy of Flickr/Ian Muttoo