Valuation

How to Calculate ESOP Valuation

Valuation, as defined in a dictionary, is an estimation of something’s worth, usually carried out by a third party appraiser.   In terms of a business, valuation is the dollar amount that a third party acquirer will pay for ownership of a business. 

 

An unofficial but broadly accepted rule is that something is worth what someone else will pay.  This is the underlying principle behind valuation calculation, and so the next factor that is considered is:  who is the buyer?

 

Buyers will value a business differently based on their intended purpose for it.  A simple non-business example here in the case of buying a car:

 

Buyer A  – wants a safe car for his 16 year son. The car needs to be reliable, safe, and the budget is fixed at $10k.

Buyer B –
wants a sports car for retirement.   BMW is the only brand that will do, the car needs to be new, and getting the options right is more important than staying within a fixed budget.

 

In these two (admittedly silly) circumstances, the two buyers have very different motives.   So it goes with the sale of a business. Buyers, particularly sale to another company, can have very different aspirations for your business and as such, will value it very differently.  

 

In general, there are two types of buyers of businesses:

 

Financial buyers — these folks will buy the business for an immediate financial payback and long-term financial gain, and thus will value the business based on:

    1. Paying off what the buyer paid for the company
    2. Surplus the buyer can expect once the company is paid for
    3. Comparison of this against other financial investment opportunities.   

 

In this case, the business is valued based on strictly financial performance relative to other investment options.

 

Strategic buyers — these buyers will be purchasing a company for the value it can add to their existing company in terms of strategic upside.  Example, a tax firm that is adding a payroll management service might seek to purchase a payroll service company rather than build the effort internally.   Financial performance will be a consideration in the purchase, however, other factors may be more significant (such as the need to remain competitive with other firms, or the business model is to grow client size by adding on services).

 

In either circumstance, the valuation process will be specific to the purchaser.

 

This doesn’t answer the age-old question of “how much is my business worth”, though.  “It depends” is basically the answer, and so we wanted to walk through an example.

 

Company for sale:  A $3M digital marketing firm that grosses $900k / yr profit.

 

A financial buyer  – may pay 4X EBITDA, $3.6M.   

A strategic buyer – may be willing to pay even less, say 3-3.5X EBITDA, or $2.7-3.15M.  

 

A third option, a sale to an ESOP, will value the business differently and represents additional opportunities for selling shareholders to increase valuation based on the willingness of buyers to pay for the business asset relative to other opportunities available.  

 

In an ESOP valuation, buyers are employees who are motivated by the long term retirement potential associated with ownership in the company they are helping to build.   This is an asset that can complement existing retirement savings, if qualified retirement plans exist, and otherwise create a viable retirement plan for companies that do not have one.  As such, and given the broad buyer base and shared risk as well as direct control over the asset, the premium for the sale to an ESOP for this marketing service firm could be as high as 5-6X EBITDA.

 

Let’s look at a comparison side by side.

 

 

Financial buyer

Strategic buyer

ESOP

Revenue

$3,000,000

$3,000,000

$3,000,000

Profit

$900,000

$900,000

$900,000

Valuation multiple of EBITDA

4X

3.5X

6X

Valuation

$3,600,000

$3,150,000

$4,500,000

 

Additionally, in the case of an ESOP, selling shareholders may make adjustments to financial uses company profits that further increase valuation, where in the case of a strategic or financial buyer, these factors are typically not considered.

 

Example:

  1. There are three partners and one is moving to a non-salaried role (taking an exit).  This partner’s salary was $100,000
  2. Healthcare was another $20,000/yr paid by the company
  3. Fuel was reimbursed for vehicles at ~$5,000/yr

The total of these expenses add backs is $125,000, which when multiplied the 6X valuation variable, equates to an additional $750,000 of business valuation.

 

Revisiting the side-by-side comparisons:

 

 

Financial buyer

Strategic buyer

ESOP

Revenue

$3,000,000

$3,000,000

$3,000,000

Profit

$900,000

$900,000

$900,000

Valuation multiple of EBITDA

4X

3.5X

6X

Valuation

$3,600,000

$3,150,000

$4,500,000

Add backs

$0

$0

$750,000

Adjusted valuation

$3,600,000

$3,150,000

$5,250,000

 

In the case of a sale of the company to an ESOP, which is not always possible, the financial gain $1.65 – $2.1M in additional sale proceeds.

 

Clearly, the ESOP is preferred, and so one should consider the implications of selling to an ESOP, which are detailed here.

 

In the event of a sale or a desired exit, there are many factors to consider.  Which kind of buyer is right for you? Do you desire your company to maintain it’s values and function as a legacy, and does that legacy coincide with employees?

 

Our goal and hope is to educate business owners on the opportunity to create a legacy through their business by considering a sale to an ESOP.  We believe this so much that we did it with our company, and we can help you assess if this is the right fit for you as well.

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