SELLING A BUSINESS

Jan 22, 2023

How to Value an HVAC Business

The HVAC industry has seen an explosion in growth over the past decade. As more private equity companies start consolidating mom-and-pop players, the valuations of HVAC companies have been driven up.

While many small business owners may struggle to find a buyer when they are ready to retire, owners of HVAC companies can rest assured that there will be an interested party when it’s time to call it a day.

That being said, it’s still worthwhile to understand the value of your HVAC business before you’re ready to sell. It’ll allow you to work with a financial planner when mapping out retirement needs. It’ll also allow you to focus on maximizing the price of your business in a sale.

As a business brokerage that specializes in “main street” businesses, we work with lots of HVAC owners across the country each quarter. Many come to our business brokers for a preliminary valuation as they start to plan for retirement, while others come ready to list and retire as soon as possible.

In this post, we’ll break down the basic process for valuing an HVAC business. That being said, if you want to get a detailed valuation of your own business, please reach out. We offer complimentary valuations to owners of small businesses in the U.S.

What is a Business Valuation?

A business valuation is an estimate of the fair market value of a business. There are a number of ways to calculate the value of a business. For small businesses, the most common method is to use a multiple on earnings. The earnings definition used for “Main Street” businesses (i.e., businesses worth less than $10M) is called seller's discretionary earnings. It’s commonly abbreviated as SDE, and we’ll get into calculating in the next section.

While the seller’s discretionary earnings are specific to a business, the multiple is often determined by the market. 

As we mentioned earlier, the influx of large buyers of HVAC companies has driven the multiples up resulting in higher valuations for HVAC companies.

The result of valuing a business with a market multiple on the business’s earnings is a number or range that represents what a buyer would likely pay for the business. We mention this in a number of our resources for business owners but it’s worth repeating: a business valuation is not supposed to result in the maximum price an owner could get, nor the price that would sell the business the quickest.

The business valuation should represent what most buyers would be willing to pay for the business given the current market and the business’s recent earnings.

What Is My HVAC Business Worth?

For small businesses in the HVAC industry, the best approach to determining worth is a multiple on SDE. Seller’s Discretionary Earnings represent the cash flow available in the business to benefit the owner or reinvest into the business. Note the phrase “benefit” the owner. Oftentimes, small business owners run a number of personal expenses through the business: healthcare for the family, cell phone bills, personal vehicle purchases, etc. Those expenses count towards SDE.

A good rule of thumb for a “discretionary” expense is whether a new buyer would need to keep paying it in order to generate the revenue. Payments on a 2021 Range Rover used by the owner’s spouse? Nope, not needed. Bonuses to employees that they have grown to expect? Yep, needed to retain employees.

1. Calculate SDE for the Past 3 Years

To calculate SDE, we add up the following:

• Net Income (reported to the IRS on the tax return)

• Interest

• Depreciation

• Amortization

• Owner Compensation (e.g., salary of the owner, healthcare and retirement benefits)

• Discretionary Expenses (e.g., family members on payroll who aren’t actively working)

The best practice is to calculate the SDE for each of the past three years so that we can calculate a weighted average. 

2. Adjust SDE for a New Owner

Once you’ve come to a number for each year, you’ll want to adjust it so that it represents the SDE a new owner would have. Here are some common adjustments we see:

• Rent: If you own the property through another entity and do not charge yourself rent, you’ll need to factor in what rent you would charge the buyer of the business. If you own property but overcharge the business rent, you’ll need to adjust the SDE to account for how much you’d really charge.

• Personal Vehicles: If you have bought personal vehicles through the business, you need to remove the interest and insurance payments from the expenses for the relevant years. 

• Family Members: If you have a few family members on payroll that would leave when you sell, you need to make sure that their work is represented correctly in your SDE. For instance, if your son draws a full salary but only works a day per week, you’ll need to remove his salary from the expenses but add back in the hourly amount you’d need to pay for someone to cover his day per week of current involvement.

Now that we have a number for Seller’s Discretionary Earnings and we’ve adjusted it for a new buyer, we need to come up with an average that represents future earnings. 

3. Calculate a Weighted Average of Your SDE

There are a number of ways to calculate a fair average of SDE across the years. At Beacon, we use a somewhat complicated formula. If you’re doing a valuation at home, we recommend that you weight the most recent year 50%, the second most recent year 37.5% and the third most recent year 12.5%.

For instance, if you had SDE of $400K, $425K, and $350K in 2022, 2021, and 2020, you would do the following: $400K x 50% ($200K) + $425K x 37.5% ($159.4K) + $350K x 12.5% ($43.7K). Adding those up would yield $403.1K. This would be your weighted average SDE.

4. Apply a Market Multiple to Your Average SDE

Once you’ve calculated your weighted average SDE, the last step is to apply a multiple to your SDE. A number of factors affect your multiple, but the main one is the size of the business.

For HVAC companies earning less than $1M of revenue, typically the multiple on SDE is 2.75 - 3.25. For HVAC companies earning between $1M and $5M of revenue, the multiple on SDE is 3.25 to 4. For HVAC companies earning north of $5M of revenue, the multiple on SDE is often greater than 4.

Using the example of SDE above and revenues of ~$2M, the value of that HVAC business would be between $1.3M and $1.6M.

Factors That Can Impact Your HVAC Valuation

• Licensing: Ensure that your HVAC business has the appropriate state licenses. We’ve seen cases where owners are not properly licensed and insured. This introduces risk to a new owner. Buyers with bigger pockets will stay away from improperly licensed businesses as they do not want to get in trouble with regulators.

• Techs & Crews: HVAC companies with techs who have been with the business for more than three years see higher multiples. Why?  A new buyer knows that he or she can rely on the employees and that the employees can help minimize risk during an ownership transition.

• Owner Involvement: Smaller companies where the owner is involved in bids and project work are valued at lower multiples. Why? The owner’s day-to-day work will need to be replaced by the new buyer, a new hire, or someone internally. The more the owner does day-to-day, the harder it will be to successfully transition him out. 

How Do I Maximize the Price of My HVAC Business?

There are a number of ways to increase the value of an HVAC business. For personalized advice, we recommend getting a complimentary valuation and speaking to someone on our team who specializes in the heating and air conditioning industry.

Aside from that, there are a few pointers for increasing the value of your business:

1. Clean up your books: At the end of the day, income reported to the government is valued higher than “discretionary expenses” that a buyer won’t have to pay. Why? It’s easy to prove income reported to the government. It’s hard to prove that a phone bill is really for your family member who doesn’t work in the business.

2. Retain quality techs: Even if it costs more to the business, finding legal and high quality labor is crucial to maximizing business value. Good, tenured workers and subcontractors help de-risk the impact of a well-respected owner leaving the business and give banks peace of mind when lending to a buyer. Moreover, these teammates can help train the buyers up on “how things are done.”

3. Get contracts in place: Regardless of whether you work in residential or commercial, having written maintenance and service contracts with your clients is important for ensuring that the buyer can pick up where you left off. These contracts are also great written proof of the reputation that you’ve built.

4. Invest in tooling: New software systems like ServiceTitan help to streamline your operations and make it easy for a buyer to come into the shop and get off to the races on your business after the deal closes.

Sam Domino

Transaction Advisor

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.