The most popular PCO question we answer at Kemp Anderson Consulting is “what’s my business worth?”  Our answer is always “it’s complicated and there are many variables” but let’s look at some popular valuation methods to give you a better idea of what companies are looking at when they determine an offer for any business.

The first valuation method is a percentage of gross annual revenue.  When Kemp first started in the pest control industry almost 30 years ago, everyone talked about “dollar for dollar” valuations. That was just an easy way for buyers and sellers to describe the value they were placing on the average business. Buyers use a multiple, or percentage of gross annual revenue, as a way to simplify valuation but it really isn’t an accepted valuation approach. The problem with a revenue multiple is that it is top line, and we all know – all revenue is not the same. As an example, door-to-door pest control companies pay a much higher labor/sales cost and generally have lower customer retention than a  traditional operation that focuses exclusively on residential pest related services.

Similarly, service line mix is going to drive other operational differences. Exterior only vs interior/exterior, solid route density vs rural routes, and retention are just a few examples that determine the percentage of overhead costs in relation to gross sales. 

Here is where a valuation based on revenue multiple misses the mark, and why we don’t see this valuation method used today; if you had to choose between buying a business doing $1.5M with $200K (13.3%) in profit versus a business doing $1M in revenue with $400K (40%) in profit, all other things being equal, the second business is going to command a significant premium compared to the first as a result of increased margin and not amount of revenue. If we had only looked at revenue $1.5M versus $1M and used a revenue multiple of 2, the first business would be worth $1.5M*2 = $3M. The second would be worth $1M*2 = $2M. However, the second business makes twice as much profit. A revenue multiple valuation ultimately serves as a gut check when thinking about what your business is worth, and in most cases, we would not recommend signing a LOI or agreeing to professional valuation that is based on a multiple of revenue. In reality, revenue multiple is a conversion of an earnings multiple and not really a valuation multiple. As an example, a company with $1mm in revenue and $250k in non-diluted earnings that sells for $1mm was paid 4x revenue. If they are paid $2mm they sell for 8x revenue.

A second valuation method is a multiple of discretionary earnings. Discretionary earnings is also sometimes referred to adjusted cash flow. A simple way to think about discretionary earnings is to quantify the total financial benefit of a company within a 12-month period (TTM trailing twelve months or calendar year). To do this, the buyer looks at the taxable revenue (found on the tax return) and then adds back expenses that the owner benefits from throughout the year. A way to think about this is, what is the business net income or profit when the seller owns the business compared to when  a buyer owns the business after close? This will include expenses such as personal cell phones, travel & entertainment, the owner’s vehicle, boats, gas, insurance, and other items that the owner has run through the business but that are not mandatory for day-to-day business operations. Once the business is sold, those expenses would not be assumed by the buyer. Those expenses are additional owner’s compensation that reduces taxable income. Buyers in our industry use a wide range of discretionary earnings multiples, depending on the location, route density, service mix, profitability, employee tenure, and many other factors. In short, benchmarking with a few other owners who have sold their business won’t give you a full picture of what drove the purchase price from a particular buyer. At Kemp Anderson Consulting, we have seen earnings multiples approaching 20x.

The third valuation method is a more sophisticated financial model that takes a lot of variables into account and blends them to come up with a range that the buyer is willing to pay. These models are custom and proprietary to each individual buyer, but they consider many of the same variables that we discussed earlier in this article. You may be asking yourself how you can move into the upper end of a valuation range. 

Locating your business in an area with a strong and growing economy adds value. Market and location matter.
Showing year over year revenue growth as well as increased profitability builds value.
A clean set of tax returns and consistent bookkeeping practices will bring value
A strong management and high employee tenure demonstrates the business is poised to grow
A higher percentage of recurring revenue and less one-time services add value.

More predictable and stable cash flow adds value.
High route density and low callback rates indicate the business is being operated efficiently and will add value.
Regular annual price increases add value to the buyer
A high percentage of auto-pay customers adds value to the buyer

What factors will reduce the value of an offer?
An overreliance on the owner for management will lower the value of the deal. 
High customer turnover will lower the value of the deal
Low pricing
High COGS (labor, chemical costs, fleet, fuel) beyond industry norms
Poor hiring practices (no drug tests, background or driving records checks)
Allowing drug use. Please remember, marijuana is still against federal law.

Understanding a few different valuation variables are meant to act as a starting point for financial guidance and shouldn’t substitute for professional advice. Seasoned buyers tend to use sophisticated blended financial models that look at a host of variables, including some of the ones mentioned above.  At the end of the day, the simple truth remains: a business is worth what someone is willing to pay.  Buyers will try to buy as low as possible, and sellers should take the time to prepare their business to maximize value and be prepared to negotiate the deal. Ultimately, buyers pay more when the business is well run and earnings are on the higher end of industry norms.  

The team at Kemp Anderson Consulting
Theresa Childs, Grant Sinnott, Kemp Anderson