A Google search for this title returns 483 million results in .52 seconds. Most articles talk about formulas used to calculate business valuation or formal appraisal methods.
If you’re thinking about selling and are stumbling through the web to roughly calculate what your manufacturing business is worth before going to market here’s what you need to know – most of what’s on the web is absolutely wrong.
Many methods of calculating value have nothing to do with how manufacturing companies trade in the current market. In this article, we’ll cover various factors that affect value.
15 Factors Affecting Manufacturing Business Valuation
- Sales and net earnings trajectory, and gross margins.
- Adjusted EBITDA or SDE.
- The company’s dependence on the owners & willingness to transition.
- Customer and sector concentration.
- Length and stability of customer relationships.
- Barriers to entry.
- Patents and unique technologies.
- Danger of new competing technologies.
- Need for capital expenditure to maintain sales.
- Supply & demand in your sector.
- Age of labor force and access to future skilled labor.
- Standard operating procedures and industry certifications.
- Value of machine tools – amount of collateral for acquisition loan.
- Debt service coverage ratio.
- Geographic and aesthetic desirableness of business location.
The determination of value is different, depending on the size of the company. A $10MM revenue company will trade at a different multiple than a $100MM company. In this article we’re only dealing with lower middle-market companies with revenues between $2-$20MM, which is where the majority of U.S. manufacturing companies land.
Sales and Net Earning Trajectory, and Gross Margins
While there are firms that specialize in turnaround situations, the majority of quality buyers want a company that is not in distress. Buyers will look for companies whose revenues and net earnings are in an upward trajectory. Companies showing growth of revenue and having gross margins of 35% and above will sell at higher numbers.
Adjusted EBITDA or SDE
Many articles available on the web talk about looking at the difference between your assets and liabilities to determine value. This is not how one should determine the value of their manufacturing business. Especially given that most manufacturers take advantage of accelerated depreciation.
You could have millions in quality equipment, but the book value might be zero if it’s been fully depreciated. Most manufacturing companies are sold at a multiple of EBITDA or SDE. Buyers will use a baseline multiple, then add or subtract based on the other criteria in the numbered list above.
According to Investopedia, EBITDA is “earnings before interest, taxes, depreciation, and amortization, and is a measure of a company's overall financial performance and is used as an alternative to simple earnings or net income in some circumstances.”
The Corporate Finance Institute says SDE or “Seller’s discretionary earnings is a cash-flow based measure of business earnings in an owner-operated business. It comprises the profit before tax and interest of a business before the owner’s benefits, non-cash expenses, extraordinary one-time investments, and other non-related business incomes and expenses.
The metric is used to measure the value of an organization in order to provide potential buyers with a better picture of their expected return on investment.” Adjusted EBITDA will include some of the additional items included in SDE. The difference between the two is that SDE includes the owner’s actual salary, while adjusted EBITDA will deduct a normalized manager's salary.
But what multiple of EBITDA or SDE is used to determine value? The answer changes with time, supply and demand for the type of manufacturing company being sold and many other factors. There is a publication which tracks M&A transactions quarterly and can be used as a baseline.
I would caution readers that using this publication without consideration of the other factors listed above will lead to an inappropriate business valuation. The publication is The Market Pulse report by Pepperdine University. Several years' worth of reports are available on their website and you can see how multiples change over time.
A word of caution here. If you are a potential buyer trying to determine what you should pay for a business, you’ll find many acquisition lending brokers who will tell you not to pay over a multiple of 3 times SDE.
These brokers do not necessarily understand what is happening in the current market; they just want to close a loan and get their commission. If you’re submitting an offer based on a 3x multiple, but companies are trading at a 6x, you’ll lose the opportunity.
Company’s Dependence on Owner and Willingness to Transition
If a manufacturing company is dependent on the owner, both buyers and acquisition lenders see risk. If something happens to the Seller before the company is properly transitioned, the buyer’s investment and lender’s loan could both be in peril.
Manufacturing companies that have managers in place for key departments and functions are more valuable. Likewise, the Seller must be willing to assist with the transition of operations and customer relationships to a new owner.
Customer and Sector Concentration
Manufacturing companies with less than 15% of revenue derived from any one customer or less than 25% from one sector will trade at higher multiples than those with higher concentrations. There are some sectors where lower concentrations are simply not possible.
For instance, those who make components for the aerospace industry always have high customer concentrations. Because of the limited number of OEMs, if a company is doing anything of relevance in the industry, they will absolutely have a customer concentration. The key in these types of transactions is to work with a national acquisition lender who understands the industry.
Length and Stability of Customer Relationship
A manufacturer with longer and consistent customer relationships is considered more valuable than one whose relationships are only a few years in length. Stability sells at higher multiples. Buyers will pay more if there are contracts in place or blanket purchase orders with timed releases throughout the year.
Barriers to Entry
Certain types of manufacturing companies would be difficult to replicate, either from a skill or startup cost perspective. Companies that would be very easy to replicate sell at lower multiples and are very hard to sell.
As an M&A professional specializing in manufacturing companies, potential clients often tell me that they have “no competition” and no other company can do what they do. My research team often immediately finds out that this is simply not true with a simple Google search. The assessment must be fact-based and data-driven.
Patents and Unique Technologies
Generally speaking, companies with intellectual property and unique technologies are valued higher. This relates back to the barriers to entry issue. Many manufacturers don’t patent products for fear of the technology being stolen. Manufacturers with unpatented technology and proprietary processes still get a bump in value.
Danger of Competing New Technologies
New technology can wipe out or severely diminish an industry. Think about what the internet and email have done to the printing industry. Companies whose products can easily be replaced by 3D printing, for example, will experience a decline in business valuation in the coming years and be difficult to sell. The speed with which technology changes makes this category one of the most scrutinized in the M&A business valuation process.
Need for Capital Expenditure to Maintain Sales
Companies who continue to upgrade their machine tools and infrastructure on the approach to selling fare better than ones who don’t. If major capital expenditure is needed, the business valuation will be lower. Owners often live in a bubble thinking their old equipment is still in good working order; therefore, there is no problem.
However, if newer technology can produce double the amount of parts, in one third the time, an acquirer will have to upgrade everything to remain competitive. A buyer can pay more for a company where less capital expenditure is needed.
Supply and Demand in Your Sector
If a skill set is hard to find and there’s demand for it, a selling company of this type will command a higher business valuation. A good example of this would be a company specializing in custom tool and die making who has a younger staff.
This is a rare breed in today’s environment, as most tool and die makers are of retirement age. These companies sell fast and sell at premium prices because the demand for them is great. Competition drives pricing upward.
Age of Workforce and Access to Future Skilled Labor
Manufacturing companies with an aging workforce experience a lower business valuation than those with a young vibrant skilled workforce. It’s a matter of risk to a buyer if the majority of a company’s workforce is nearing retirement. Companies who are proactive about ensuring access to future skilled labor also fair better. Grassroots apprenticeship programs are gaining in popularity for this reason.
Standard Operating Procedures and Industry Certifications
Companies with documented operating procedures are easier to sell and sell at higher numbers than those without. SOPs tell a buyer and a bank underwriter that the company can be easily transitioned.
While some business owners do this automatically, it’s required in industry certifications like ISO and AS9100. Companies with these types of certifications will receive a bump in their valuation.
Value of Machine Tools - Amount of Collateral for Acquisition Loan
Bank underwriters look at a manufacturer’s cash flow to determine the amount of the loan, not the value of the equipment. However, they look to the value of equipment to determine their collateral should the loan go bad. They want security and usually have strict loan-to-collateral ratios.
If the value of the equipment doesn’t fall into these parameters, the lender will seek additional collateral from an acquirer. Buyers prefer and will pay more if a business has higher valued machine tools.
As a side note here, manufacturers often think the value of their equipment should be in addition to the purchase price. It doesn’t work that way. There is no business or cashflow without the equipment. It’s part of the purchase price.
Debt Service Coverage Ratio
As Corporate Finance Institute explains, “The Debt Service Coverage Ratio (DSCR) measures the ability of a company to use its operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debt.”
In manufacturing M&A, the DSCR is used to measure the ability of an acquisition target’s cash flow to cover the debt service required to make the acquisition. While the SBA has a minimum DSCR of 1.15, many lenders have higher internal rates. Setting a list price that would generate an inappropriate DSCR means the company will not sell.
Many business owners will argue that a buyer should simply put more money down to bring the DSCR in line. The problem is, they won’t do that if they can get a better return on a competing acquisition putting less money down.
Geographic and Aesthetic Desirableness of Business Location
A manufacturing company in a desirable area with access to skilled labor, health care, good schools and cultural activities will sell at higher multiples because of the competition among potential acquirers. This is not to say that there aren’t companies in very rural communities that can sell at a good price, but the desirableness of a region attracts buyers, which drives competition and thus price.
Likewise, companies with good curb appeal are more likely to sell at a higher price. When buyers see a well organized and clean manufacturing plant, they see a company that will be easy to transition. This drives pricing up.
If you’ve been wondering, “What’s my manufacturing business worth,” the thought you should come away with after reading the top 15 factors affecting value is that there is no formula. Every manufacturing company is unique.
If you’re enlisting a professional to help you determine the value, they must take all of these things into consideration to come up with a true value. Not doing so might mean that you’re either leaving money on the table or setting an unrealistic value.
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