What’s so special about $1 million in earnings?

What’s so special about $1 million in earnings?

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, an average company with $200,000 in EBITDA might be valued at three times EBITDA, or $600,000. A company with a million dollars in EBITDA would likely command at least five times that figure, or $5 million. So the company with $1 million in EBITDA is five times bigger than the $200,000 company, but almost 10 times more valuable.  Note that IT companies such as managed service providers, software, or cloud solution providers may have higher multiples than other industries, but the larger firm will still have a higher multiple.

There are a number of reasons that offer multiples go up with company 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 to 20X Rule of Thumb

If you look at a lot of deals, the acquiring company is between 5 and 20 times the size of the target company.  If an acquiring business is less than 5 times your size, it is a bet-the-company decision for the acquirer:  If the acquisition fails, it may like kill the acquiring company.

Likewise, if the acquirer is more than 20 times the size of your business, the acquirer will not enjoy a meaningful lift to its revenue by buying you.  Most big, mature companies aspire for 10 to 20 percent top-line revenue growth at a minimum. If they can get 5 percent of organic growth, they will try to acquire another 5 percent through acquisition, which means they need to look for a company with enough girth to move the needle.

3. Private Equity

Private Equity Groups (PEGs) make up a large chunk of the acquirers in the mid market. The value of your company will move up considerably if you’re able to get a few PEGs interested in buying your business. But most PEGs are looking for companies 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, or colleges that look for a minimum SAT score, if you don’t fit the minimum criteria, you may not be considered.

If you’re close to a million dollars in EBITDA and want to learn how to to sell your company, you may want to hold off until your profits eclipse 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.

Republished with permission from Built to Sell Inc.