Determining a Reasonable Valuation Earnings Multiple For a Childcare Business

By: Jay Whitney

The previous article on “Calculating Cash Flow Of A Childcare Business” discusses how a Seller’s Discretionary Earnings (SDE) is calculated. With the SDE calculated, a reasonable earnings multiple must be determined to be multiplied against the SDE. This article explains the factors that determine a reasonable and supportable earnings multiple for the childcare center business.

For single location childcare centers, the multiple of SDE can be as low as 1 or 1.5 for very small childcare businesses. For many childcare centers the multiple of SDE is often in the 2.5 to 3 range. For larger, more profitable centers, the multiple of SDE can be as high as 3.5 to 4.5. For small chains of very profitable childcare centers, the multiples of SDE are often higher, although the multiple of earnings would be generally be based on the Adjusted EBITDA.

The Company Specific Risk (CSR) incorporates all the factors used to differentiate the factors of one specific childcare center to other childcare centers, as well as evaluate the overall childcare center industry. The CSR factors include the following:

As the Company Specific Risk factors decrease, the earning multiple increases. Conversely, as risks increase, the multiple decreases. To provide more details on the table above, each factor that determines the value of a childcare business is discussed below:

Owner Involvement – Some childcare center owners have minimal involvement and are absentee owners (low risk), and some owners are the face of the center and work long hours (high risk that if a new owner were to take over the center, that performance would suffer).

Transferability of Revenue – In some centers, where the owner is both the face of the center and the director, parents will be very concerned if the owner leaves and some may pull their children out of the center (high risk). In other centers, very few parents know who the owner is because they interact with the director. As long as the director stays at the center, there is a low risk.

Continuation of Revenue/Customer Loyalty – In some centers, the children tend to say enrolled for many years (low risk), while in other centers, the children are, on average, enrolled for only a couple of years (high risk). When teachers leave a center, some parents also dis-enroll their children. Centers which have a high turnover of teachers are higher risk.

Key Woman/Man – In some childcare centers, when the owner sells, the director also leaves, and consequently teachers leave, which creates a high risk that parents will leave.

Management Depth – In some centers the assistant director is capable of taking over the role of the director if the director were to leave; a teacher is capable of becoming of becoming the assistant director; and teaching assistants are capable of becoming teachers (low risk).

Size of Potential Buyer Pool – The buyer pool is small when the owner is also the director because a buyer must also be a licensed director in that particular state (high risk). Otherwise, the buyer pool tends to be large (low risk).

Barriers Of Entry – To convert a building that is not already set up as a childcare center can be very expensive to meet the current licensing requirements of the state’s childcare agency that regulates childcare center (low risk that a new competitor will enter the local market). To build a new childcare center is also very expense. A brand new childcare center is often not profitable until nine to twelve months after it opens, so, an owner needs to be able to support herself until the center is profitable (low risk). Some centers have competitive childcare centers that are operating at substantially below capacity (high risk that an existing competitor can, at a low cost, increase enrollment). A nearby vacant childcare building will increase the risk because it could be easy for a new competitor to open up a new childcare center.

Some childcare centers are in school districts who are considering adding an After-School-Program in their elementary schools (high risk).

Churches often have mothers-morning-out care. Licensing for a full-day childcare center, can, depending on the state, have different facility requirements that mother-morning-out care which can be expense (or not) (low or high risk depending on the state requirements and nearby church offering mothers-morning-out care). Setting up a home-based childcare business is easy and doesn’t take much capital (high risk).

Condition of Financial Records – Some centers have poor financials records and operate out of a shoe box and only gives their accountant the financial records at tax time. In this case, from the buyer’s viewpoint, there is a higher risk that the records are not completely accurate.

Growth Prospects – Some centers are operating with low enrollment compared to capacity, and have the ability to significantly increase enrollment (low risk). Other centers are operating at full capacity (higher risk because enrollment can only go down, but not up). Some centers have the ability to increase enrollment by a significant number without increasing the number of teachers because, for example, they have two teachers, and 12 children enrolled in a room that has a required child/teacher ratio of 10/1. Following this example, this center would be able to increase revenue by enrolling 8 new children in this one class without any change in labor costs (low risk).

Location – Some childcare centers are in a market area with good demographics and traffic counts in front of the center (low risk). Other centers are hidden away with poor traffic counts and not very good demographics, so to make it harder to increase enrollment (high risk).

Marketability / Brand recognition – Franchisees of childcare centers with many locations within a center’s market area tend to have lots of marketing and brand recognition (low risk). Some centers spend next to nothing on marketing and don’t have much brand recognition (high risk).

Service Mix – If a childcare center is doing well and has a wider service mix than most centers, there is lower risk. For example, if a center is doing well with evening care, summer care, or kindergarten (in addition to the normal services); there is a lower risk.

Customer Concentration – Some childcare centers may be operated by a church and get a significant percent of children from the congregation (high risk if a buyer, who is not in the church, buys the childcare business). Some childcare businesses have a high percent of their enrollment come from just one government program (high risk because there could be changes in that one government program that significantly affects revenues)

Industry Trends – The childcare industry is negatively affected (high risk) when:

There are fewer children in the prime ages that use childcare centers
There is high unemployment or it is increasing.

Age/Value of Furniture & Fixed Assets – Some centers have old furniture and a facility that will have to be replaced or spruced up (high risk because: 1) it is often harder to enroll kids in a poorly maintained childcare center, and 2) the cost of sprucing up).

Financial Strength (Level of Profitability / Cash Flow Margin / Risk of High Overhead) – Childcare centers with high overhead expenses have a higher risk than those centers with lower overhead expenses because centers with low overhead can see their enrollment decline and they still be profitable, while a center with high overhead needs lots of kids enrolled to breakeven. Centers that are very profitable have a lower risk than those centers that are marginally profitable. If a childcare center’s business owner is required to personally guarantee a high rent amount to a landlord, this will increase the business owner’s risk, and decrease the value of the business.

From the Buyer’s viewpoint, if, for example, a childcare business is producing $200k in SDE after paying all expenses including only $150k in Fair Market Value (FMV) Rent, that business is worth more than an similar childcare business is producing $200k in SDE after paying $300k in FMV Rent. The reason is because of the additional risk associated with a much higher overhead caused by more expensive real estate. Higher overhead increases the risk whenever there is a recession.

Business Systems & Procedures – Traditionally, childcare centers are low-tech businesses, and still, many childcare centers use little, if any, technology. Centers using little technology, systems, and procedures often can’t show that the center is not being managed by “the-seat-of-the-owner’s-pants”. A seat-of-the-pants management style makes a transition to a new owner more difficult with a greater risk of some type of disruption to the revenue / earnings.