$1 Million EBITDA Doesn’t Automatically Mean a $5 Million Business

I occasionally hear an owner say, “Businesses in my industry sell for 5x EBITDA. We make $1 million, so the business is worth $5 million.”

Well, maybe. $1 million of EBITDA could support a $5 million valuation, or it could support a $1 million valuation. The amount of EBITDA is only part of the story. The bigger question is how much confidence a buyer can have that those earnings will continue.

Consider two companies generating exactly the same EBITDA. The first has a strong management team, diversified customers, recurring revenue, clean financials, documented processes and a history of consistent performance. The owner is important, but the business doesn't revolve around them. There is a clear path for a buyer to take over and continue producing that $1 million.

Now take the second company. Same $1 million EBITDA, but one customer represents 50% of revenue, the owner controls most key relationships, financial reporting is messy, outdated equipment will require significant CapEx in the next two years, and CoGs have been bouncing around.

Same EBITDA, but two very different businesses.

The multiple reflects the risk behind the earnings. The more evidence we have that the earnings are sustainable and transferable, the stronger the valuation we can justify. The more uncertainty a buyer has to accept, the harder it becomes to justify a higher multiple. Higher risk demands a lower price, or a deal structure that mitigates some of the risk for the buyer, like seller financing, an earnout, a holdback or other contingencies.

This is why I don't like starting a valuation conversation with, “What's the multiple for my industry?” There is no single multiple that applies equally to every business in an industry.

Doing the math, $1 million × 5 = $5 million, is easy. Justifying the 5 is the hard part.