The million-dollar mark is a tipping point at which the number of buyers interested in acquiring your business goes up dramatically. The more interested buyers you have, the better multiple of earnings you will command.
Since businesses are often valued on a multiple of earnings, getting to a million in profits means you’re not only getting a higher multiple but also applying your multiple to a higher number.
For example, according to our research at The Value Builder Score, a business with $200,000 in EBITDA might be lucky to fetch three times EBITDA, or $600,000. A business with a million dollars in EBITDA would likely command at least five times that figure, or $5 million. So the business with $1 million in EBITDA is five times bigger than the $200,000 company, but almost 10 timesmore valuable.
There are a number of reasons that offer multiples go up with business size, including:
1. Frictional Costs
It costs about the same in legal and banking fees to buy a company for $600,000 as it does to buy a company for $5 million. In large deals, these “frictional costs” become a rounding error, but they amount to a punitive tax on smaller deals.
2. The 5–20 Rule
I first learned about the 5–20 rule from an adviser named Todd Taskey who runs an M&A firm in the Washington, D.C. area. He discovered that, in many of the deals he does, the acquiring business is between 5 and 20 times the size of the target business. I’ve since noticed the 5–20 rule in many situations and I believe that more often than not, your natural buyer will indeed be between 5 and 20 times the size of your business.
If an acquiring business is less than 5 times your size, it is a bet-the-company decision for the buyer: If the acquisition fails, it will likely kill the acquiring business.
Likewise, if the buyer is more than 20 times the size of your business, the buyer will not enjoy a meaningful lift to its turnover by buying you. Most big, mature businesses aspire for 10 to 20 per cent top-line turnover growth at a minimum. If they can get 5 per cent of organic growth, they will try to acquire another 5 per cent through acquisition, which means they need to look for a business that’s big enough to move the needle.
3. Private Equity
Private Equity Groups (PEGs) make up a large chunk of the buyers in the mid market. The value of your business will move up considerably if you’re able to get a few PEGs interested in buying your business. But most PEGs are looking for businesses with at least $1 million in EBITDA. The million-dollar cut-off is somewhat arbitrary, but very common. As with homebuyers who narrow their house search to houses that fit within a price range, if you don’t fit the minimum criteria, you may not be considered.
If you’re close to a million dollars in EBITDA and getting antsy to sell, you may want to hold off until your profits pass the million-dollar threshold, because the universe of buyers — and the multiple those buyers are willing to offer — jumps nicely once you reach seven figures.