If I had to guess, you’d value your business based on whatever the last acquisition in your space reportedly went for. Maybe it’s a number based on a multiple you heard from another owner. Five times EBITDA. Six times?
The issue is that the multiple gets the attention, when it really should be the last step in a longer process. For processors, distributors, and manufacturers, your process must account for trickier details, like depreciation, building leases, and seasonal swings in raw materials.
Here are the five rules that determine whether your valuation holds up.
Rule 1: EBITDA is Where You Start
Let’s break down what EBITDA stands for. Earnings before interest, taxes, depreciation, and amortization. For businesses, this acronym also forms the foundation of your valuation methodology by removing financing decisions and focusing on day-to-day performance.
For rule one, your raw EBITDA gives you a starting point. But this number, pulled straight off your financial statements, almost never reflects what a buyer would pay for.
Why?
It instead reflects how you’ve chosen to run the business, including decisions a future owner might not make the same way. This is why it’s your starting point. If you treat that raw number as your valuation, you’re making rule 1’s most common mistake.
Rule 2: Owner Compensation Gets Restated to Market
Many manufacturing owners don’t pay themselves what the role is worth. Instead, it’s just the number set by history. Generally, this is a lot of guessing.
But how do owner compensation errors impact your business valuation?
If you’re taking $150,000 out of a business that would need to be $220,000 to replace you, the thousands of dollars in that gap gets added back during EBITDA normalization. The adjustment runs in the other direction if you’re overpaid relative to the role.
Here’s the impact of over- and under-compensating:
- Overcompensation: Paying yourself far more than a hired manager would cost causes the net income and EBITDA to drop. This makes the business look less profitable than it is.
- Undercompensating: Owners who take a low salary to boost cash flow appear artificially high-profit, and a buyer must subtract a realistic replacement salary.
In a manufacturing valuation, this is a very common correction, and it’s easy to get wrong if you’re not documenting your market-based comparisons.
Rule 3: One-Time Costs Don’t Belong in an Ongoing Number
One-time costs are real and temporarily depress your reported earnings. But, as I mentioned, this is only temporary and doesn’t reflect what your business earns in a normal year.
These are costs like:
- New roof on the plant
- Lawsuit settlement
- One-off equipment breakdown
- Flooding that shut down production
Normalizing your EBITDA adds these costs back while flagging anything likely to recur. For example, if your aging equipment keeps breaking, this is a different conversation than a one-time event.
So, to find out the true structural profitability of your operations, add the non-recurring expenses back into earnings.
Rule 4: Related-Party Deals Get Restated
This is common in family-owned manufacturing. Say your plant building is owned by a separate LLC controlled by the family, and your rent is well below market. Or, in another case, raw materials are purchased from your relative at a price that you wouldn’t see in an independent deal with a supplier.
These related-party relationships get restated to what these transactions would generally look like at arm’s length, because a buyer isn’t going to inherit your family’s internal arrangements.
It’s important to look closely at these common areas:
- Personal Expenses Through the Business: Remove non-business expenses entirely from financial statements.
- Shareholder Loans: Interest rates on loans need to be adjusted to reflect the market interest rate.
- Real Estate Leases: If renting your facility from an affiliate or owner, adjust the rent expense to match prevailing market rates.
- Intercompany Sales and COGS: If you bought from or sold to affiliates, adjust the prices to reflect standard market prices.
- Owner & Executive Compensation: All salaries and bonuses need to be replaced with fair market value to reflect what it would cost to hire an independent professional.
This rule, combined with rule 2, is what turns raw EBITDA into adjusted EBITDA. This is the number a valuation professional is more likely to work off of, but still should not be relied upon alone.
Rule 5: You Must Get Rules 1 Through 4 Right First
Once you have adjusted EBITDA, the multiple applied to it reflects things like:
- Industry risk
- Growth trajectory
- Customer concentration
- How replaceable the owner is
Here’s a realistic example:
Two manufacturers with identical revenue can land on very different multiples, and it has nothing to do with normalization. One manufacturer has three customers accounting for 70% of sales; the other has a diversified book of 200 accounts,
The only thing that matters here is whether their adjusted EBITDA is wrong.
A multiple applied to an inflated number produces an inflated valuation that won’t survive a buyer’s own diligence process. When it comes to your eventual sale, partner buyout, or succession plan, a multiple applied to a conservative number might undervalue your business.
Read more about preparing for a business valuation.
What This Means if You’re Planning Ahead
If you’re seeing a transition of ownership somewhere on your horizon, whether that’s in the next decade or even more years out, these five rules are worth understanding now.
These steps can also help make your eventual valuation process smoother:
- Cleaning up related-party arrangements
- Documenting the reasoning behind owner compensation
- Keeping track of all recent renovations and additions
- Separating one-time from ongoing costs
If you’re a manufacturing business owner wondering how to value your business the right way, let’s talk well before you start questioning your multiple. Meetings with MBE CPAs start with these five business valuation rules, which we’ve learned through years of experience in the manufacturing industry dealing with these sorts of mistakes.
Our team is ready to help you with anything from simplifying your accounting to identifying opportunities to improve your operations.