As is the experience of many valuation analysts, clients are typically unfamiliar with the language and mechanics of corporate finance as it relates to business valuation or business brokerage.  For these equity owners, it is best to define valuation as a simple algebraic expression that they can easily digest.

Market Value = Multiple x Financial Metric

In other words, the value of a business is determined by the Company’s financial performance multiplied times a market-derived multiple. The client’s industry will dictate what type of multiple and financial metric is inserted here. As the saying goes, “cash is king”. Accordingly, free cash flow is one item that an internal or external buyer is often interested in.  Think of free cash flow as the amount of money leftover at the bottom of your check register that is available either to service your debt OR distribute to shareholders.  This can also be thought of as the amount of time it would take for a prospective buyer to recoup their investment strictly from the Company’s available free cash.

A Company’s EBITDA (net earnings before interest, taxes, depreciation and amortization) serves as a good proxy for free cash flow.  Consequently, this discussion will focus on an EBITDA multiple applied against EBITDA.

Therefore, our original equation becomes, Market Value = EBITDA Multiple x EBITDA

With this background out of the way, we will now step inside the EBITDA side of the equation to focus on an often overlooked but critical expense line that impacts EBITDA, your subject company’s rent expense line.

In any exit planning or succession planning assignment, a valuation analyst will put together financial projections of the subject company in order to estimate what the Company’s free cash flow or EBITDA will be post transaction.  An expectation of a Company’s rent expense post-transaction is a critical component of this estimation.

Many times, a business owner also owns the real estate that the business operates out of but within a separate legal entity.  If this is the case, the sale of the Company does not always include acquiring the business’s property.  In this instance, the seller would become the landlord for the potential buyer, and the potential buyer will desire clarity and certainty on what their rent will be post transaction.

Another complication may occur if the Company is receiving below market rent. Can the buyer expect the same level of expense or will the landlord raise the rent expense to market levels?  Unless the buyer can negotiate a similar deal with the landlord, a valuation analyst would assume the latter scenario to be more likely. Thus, in this situation the projected cash flow or EBITDA may be too high if it incorporates historical rent expense levels.

For example, let’s say you compute the Company’s EBITDA to be $500,000 based on historical financials, where the total rent expense was based on a $10 per square foot lease agreement.  Because the business is located adjacent to the Avalon, a real estate specialist estimates that market rate would be closer to $20 per square foot.  Using a valuation framework, it would be reasonable to assume the seller will adjust the Company’s rent to market rates, resulting in a doubling of the rent expense. This would lower the Company’s projected EBITDA and, in turn, lower market value of the Company based on the equation above.  Therefore, it is critical for both buyers and sellers to analyze rent expense and not just take the financials reported EBITDA at face value.