In part one of this series, I talked about why your management company probably isn't worth what you think it's worth. In spite of the fact that you have put your body and soul into this business, sweat equity does not equal real world value. (If only it did, I would be a millionaire many times over!)
So how do you determine how much it actually is worth? That calculation will be the subject of today's post.
The standard valuation formula
A management company can be valued a couple of different ways. The traditional way is to multiply the EBITA (Earnings Before Interest, Taxes and Amortization—basically the profit before deduction for these items) by a factor of 3 to 6 times. That’s a good starting point to determine value.
EBITA - Let’s break down the pieces for a better understanding…
Earnings – calculated by taking the total revenue minus the total expenses of the management company.
Before – Earnings are adjusted to factor out the following:
Interest – paid on LOANS such as mortgages, lines of credit, business loans or any other interest paid on debts of the management company.
Taxes – This refers to INCOME TAX paid to Local, State or Federal government agencies which is paid by the management company. This would NOT include employer payroll taxes which are part of normal operating expenses.
Amortization – DEPRECIATION expense on assets owned by the management company, such as, furniture, equipment, real estate owned (like an office building), vehicles, etc. Depreciation is a non-cash expense which is why this expense item is factored out when calculating the actual earnings of a company.
What if I am not making a profit?
Some management companies are break-even, so the traditional method of determining value may not apply. But even break-even, the company is worth something. There is value in every management company because it is an ongoing business entity that owns management contracts that are generating revenue.
In this case, the prospective buyer has to look at the compensation level of the current owners and the personal “perks” and expenses being run through the management company to factor those out and recast the “normalized” profitability of the company. Then apply the multiple of 3 to 6 times to the result.
Here's an example of what that might look like:
High salary, bonuses or profit distributions for the owner.
Owner’s relatives, who don’t work at the company, or only work limited hours, receiving salary or benefits.
Owner’s vehicles funded by the company.
Special benefits, like life insurance or a retirement plan, that only the owner receives.
Vacation and personal travel recorded as business expense.
Memberships, like gym memberships, country clubs, etc. in the company's name.
Cable TV or other subscriptions at the owner’s home, funded by the company.
Services/maintenance expenses for the owners home or vehicles.
Vacation homes in the company name.
Any other non-standard expense run through the business that would typically be an individual expense if that person were not the owner of the management company.
Removing these and other non standard business expenses will help you determine an adjusted profitability amount.
3x to 6x is a big spread! Which should I use?
It's true that there is a big difference in the size of the check you get (or write) depending on the valuation multiplier. Unfortunately, there is no hard and fast rule of the value within that spread. It is up to the seller and the buyer to agree that the company is worth that much. This is where your stellar negotiation skills will apply. However, there are ways to increase the perceived value, and thus the multiplier prior to negotiations commencing.
In the next (and final) installment of this series, we will look at the factors that affect the valuation of your management company, how you can increase the value, and what you might be doing that is dragging your value down.
Want to talk more about the science of buying and selling management companies? Join James Bradley, MBA at the CAMfire Conference in February for his highly anticipated session on Buying and Selling!