Understanding Business Exits: How Businesses Are Valued – 4 Frameworks

When it comes to selling your business, understanding how it’s valued is crucial. The process of valuation can seem complex, but it becomes more manageable when broken down into four primary frameworks: yield, growth, comparables, and multiple expansions. These frameworks provide a comprehensive approach to evaluating your business, ensuring that you maximize its value during an exit.

Yield & Growth

Yield: The Foundation of Business Valuation

The first framework to consider is yield, which essentially refers to the return on investment that your business generates. When you buy a business, the price you pay is typically correlated with the yield it produces. For instance, if you pay a 10 times multiple for a business, you’re expecting a 10% return on your investment each year, assuming the business’s performance remains stable.

Yield is a fundamental concept because it ties the business’s value to tangible financial metrics. By comparing the yield from your business to other investment opportunities, such as bonds or real estate, you can contextualize its value. Historically, asset-light operating companies have traded at multiples yielding around 20%, translating to a five to six times multiple.

Understanding yield helps set a baseline for your business’s value, grounding the valuation process in clear, concrete financial terms.

Growth: Capturing Future Potential

Building on yield, the next framework to consider is growth. Growth encompasses both the annual cash flows generated by your business and the appreciation in its value over time. When evaluating a business, potential buyers look at how much cash it will generate each year and how much its value will increase during their ownership.

Growth is critical because it introduces a dynamic element to business valuation. It’s not just about the current return on investment but also about future gains. This is where the concept of the Internal Rate of Return (IRR) comes into play, measuring the overall profitability of an investment by considering both cash flows and appreciation.

By focusing on growth, you highlight the potential for your business to increase in value, making it a more attractive proposition for buyers. This future-oriented perspective is essential for maximizing your business’s valuation.

Relative Value & Multiples Growth

Comparables: Benchmarking Against the Market

The third framework involves comparables, or “comps.” Comps are used to assess your business’s value based on the prices paid for similar businesses. This approach provides an external benchmark, grounding your valuation in market realities. By looking at what similar businesses have sold for, you can justify your asking price and ensure it aligns with market standards.

Comps are particularly useful for larger transactions, where market data is more readily available. For smaller businesses, the variability can be greater, but comps still offer a valuable reference point. When negotiating a sale, both sellers and buyers use comps to support their valuation arguments, making it crucial to have a well-researched and substantiated set of comparables.

Multiple Expansion: Strategic Value Enhancement

The final framework is multiple expansion, which involves buying businesses at lower multiples and selling them at higher ones. This strategy leverages the idea that the value of a business can increase significantly through strategic aggregation and growth.

For example, if you buy several small businesses at a six times multiple and aggregate them into a larger entity, the combined business might sell at a higher multiple, such as ten times. This process of aggregation and strategic growth leads to what is known as multiple expansion, where the value of the whole is greater than the sum of its parts.

Understanding multiple expansion helps you position your business as a strategic acquisition target, enhancing its appeal to buyers looking to capitalize on this value-creation opportunity.

Conclusion: Integrating the Frameworks

These four frameworks—yield, growth, comparables, and multiple expansion—work together to provide a comprehensive approach to business valuation. Yield establishes the baseline financial return, growth captures future potential, comps offer market benchmarks, and multiple expansion highlights strategic value enhancement.

When preparing to sell your business, it’s essential to integrate these frameworks into your valuation strategy. By understanding and articulating the yield, growth prospects, market comparables, and potential for multiple expansion, you can present a compelling case to potential buyers.