Any business owner seeking to sell his or her company can benefit from an understanding of the basic math behind a buyout and the variables that drive the valuation of a company.

Let’s look at a quick example to see how a buyout fund considers the value in your company and what your company can do to make it an attractive investment for that investor.

Let’s say your company has $4 million in annual revenue and $400,000 in annual net income. Just to keep things simple, let’s assume your net income is the same as your EBITDA (earnings before interest, taxes, depreciation, and amortization). You have been increasing your sales about 10 percent a year, and your EBITDA has always been about 10 percent of that top line.

Here are the five things a buyer considers when doing the math on your company:

1. Multiple of EBITDA

The investor thinks of the value of your company as a multiple of EBITDA. They are considering what the future stream of cash flows from your company will be worth. A simple way to think about the value of your company, in this framework, is to assign your annual cash flow a multiple. In this example, let’s say a buyer thinks your company is worth five times EBITDA right now, or $2 million.

2. Growth in revenue

Your company has grown well over time, but the investor most likely will consider a scenario in which that growth isn’t quite as fast. In this case, assuming a 5 percent compounded annual growth rate, your revenue will grow from $4 million to $5.2 million over the next five years.

3. EBITDA margin

Let’s call your EBITDA divided by your revenue your EBITDA margin. Right now, it is 10 percent. Because your company will be valued as a multiple of EBITDA, growing EBITDA by either increasing revenue or increasing your EBITDA margin is very valuable. Let’s assume you are able to make your company a bit more efficient over time, so your EBITDA margin climbs to 12 percent by the end of five years, yielding EBITDA of $610,000.

4. Amount of leverage

The investor is likely to use debt to purchase your company, as the company has nice cash flow and can service that new debt. Let’s assume the investor will finance half of the purchase price of your company–$1 million of the total purchase price of $2 million.

5. Ownership 

Finally, you and your investor need to negotiate how much of the company they are actually buying. If they buy 80 percent of your company, and your company is valued at $2 million, they write you a check for $2 million. They will ask to roll over 20 percent of the equity also, so you will put $200,000 back into the company (and they will invest $800,000, with the other $1 million being debt). Another way of thinking of it is the investor buys 100 percent of your company, and you buy 20 percent back on the same terms that the investor has.

There are other drivers in the financial model: tax implications; cost of interest on the debt; whether  there will be a mezzanine layer of financing; and identifying the best projections that best represent the company’s prospects.

So why does the buyout investor invest? We need to run the same valuation model when you each sell the company to the next buyer to figure that out. 

Let’s give you both a little upside by saying that in five years, with your 5 percent annual revenue growth and by increasing your EBITDA margin to 12 percent, your next buyer is willing to pay six times EBITDA. That translates into a purchase price of $3.68 million.

One million dollars of that purchase price pays off the debt the previous investor borrowed to finance your original deal, leaving $2.68 million to be split between you and the investor. Your $200,000 has now turned into $540,000, and their $800,000 is now worth $2.14 million; you both have made 2.7 times your investment. The $1 million of debt creates value for the investor and for you. If that piece of debt were replaced by equity, the investors would still sell the company for the same price, but their return multiple would drop from 2.7 times their investment to 1.8 times, as they have to put up more capital for the same return.

Now, all buyouts don’t go like that. If things don’t go well, you and your investor can get wiped out, and you could be fired, too. But you can see the attraction: Take some money off the table now, keep your company growing, and then sell it for more upside later.

As in any transaction, you will need to find the right long-term investor and create a competitive situation so you get multiple bids. But do the math, and you can see why a buyout might make sense for your company.

By Ed Powers Head of Capital Access Funds, Bank of America

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