Sources of Financing for Businesses

Businesses for sale can be classified by deal-size. Businesses that are valued below $ 2 Million are classified as main-street businesses, businesses valued between $2 Million and $5 Million are classified as lower middle market, while businesses that are above $5 Million are classified as upper middle market. This blog tends to focus on main-street and lower middle market businesses.

Main-street and lower middle market businesses need to raise money for several reasons. Some common reasons are business growth and expansion, working capital fluctuations, refinancing existing loans, replacing existing equipment, and paying the owner. Financing for growth and expansion is the most common reason for main-street and middle-market businesses.

There are several sources for financing business operations or businesses acquisitions. Some of these sources are:

  1. Friends and Family
  2. Government grants
  3. Crowd sourcing
  4. Trade credit
  5. Personal credit cards
  6. Personal loans
  7. Business credit cards
  8. Lease
  9. Bank and Credit Union loans
  10. Asset based lender
  11. Angel Investment
  12. Venture capital
  13. Private equity investment
  14. Mezzanine lender

Bank loans are the most common source for financing business acquisitions and business operations. Asset based lending is also commonly used.  Asset based lending refers to lending secured by an asset. If the loan is not paid the asset is taken over by the lender.

Angel investment, venture capital investment and private equity investment plays a key role in raising money. These investors provide capital for ownership equity or convertible debt. Interestingly, business and personal credit cards are also commonly used for short-term financing of business operations.

Mezzanine lenders provide the additional (incremental) funding required for completing a business acquisition or business expansion project. It is usually structured as a hybrid between debt and equity financing for business expansion. Mezzanine financing may be debt financing, but gives the owner the right to convert debt to ownership equity in the company at a set price.

Business Valuation Metrics (Seller’s Discretionary Earnings)

Businesses exist to make a profit for their Shareholders. Profit is also known as income or earnings for large-cap public companies. There are three terms that represent the concept of profit and it is critical small businesses understand the difference. Profit or earnings can be expressed as Net Income, EBITDA (Earnings before Income Taxes and Depreciation) and SDE (Seller Discretionary Earnings).

Net Income also known as bottom-line is the most commonly used metric to quantify profit for middle market and large cap companies. It can be easily found on the Income Statement. However, Net Income (NI) provides a skewed picture for small business that may be owner operated. Typically, small businesses want to reduce taxes, so they maximize expenses to reduce their EBIT (Earnings before Interest and Taxes). As such, Net Income is not a good metric for small businesses.

Another metric for profit commonly used by large and middle market companies and private equity groups is EBITDA. Private equity groups like to use EBITDA because it is a quick approximation of the businesses operating cash flow. EBITDA is also useful for larger businesses because it expenses the management and operations. Private equity groups do not get involved in day to day management of the company, so it is important to factor in management cost. The rationale that makes EBITDA good for mid to large companies is what makes it bad for small businesses, where the owner expenses must be added back to EBITDA get a true picture for earnings.

Seller’s Discretionary Earnings (SDE) is the mostly widely used metric for small business valuation. SDE represents the earnings of a small business more accurately because it makes adjustments for owner operator expenses. The simplest way to conceptualize SDE calculation is by taking the EBITDA and recasting owner expenses. Owner’s expenses must include owner’s salary, bonus and all benefits. The technique may be used to roughly estimate the SDE for a small business. Conversely, one can conceptually go from SDE to EBITDA by subtracting owner’s expenses. So, EDITDA = SDE – (Owner’s Salary + Benefits) and SDE = EBITDA + (Owner’s Salary + Benefits). When SDE is used with a multiple to value a business it’s called multiple of discretionary earnings. Multiple of discretionary earnings are best suited for owner operated businesses. Besides buying and selling businesses, SDE is also useful for comparing businesses. Seller’s Discretionary Earnings (SDE) is also sometimes called Seller’s Discretionary Cash Flow.

Business deals on the main street (0 – $2 Million) are typically based on SDE. Business deals in the lower middle market ($2 Million – $5 Million) are usually based on EBITDA. For vast majority of main street businesses working capital is not included in the value of the business.

There are several techniques to business valuation including asset based methods, earnings based methods and market based methods. Rule of thumb based valuation of a business is typically a multiple of SDE or EBIT. The multiplier for your business depends upon several factors including sector, industry, location, deal-size, deal structure, economic climate, financing, number of buyers and so on.

Please note / Disclaimer: Business owners must work with a business professional such as a business broker or chartered accountant (CA) to get an exact estimate for their business. The techniques described here is for business owners to conceptually understand Seller’s Discretionary Earnings (SDE), which plays a critical role in business valuation.

Introduction to Business Valuation

Non-Financial Due-DiligenceValuing a business should not be put off to the last minute when a business is looking for an exit. Most business and finance professionals agree keeping valuation numbers current is a good idea. Using valuation as a measurable key performance indicator (KPI) allows the owner to continuously make changes that maximize value. Valuing a business frequently provides the owner several additional insights such as whether selling the business will provide sufficient funds to retire or whether merging a business is a better option to selling the business.

Overall, there are several reasons to value a business where buying or selling a business is the most important one. Reasons to value a business can be summarized as:

  • Keeping score of value created
  • Making changes continuously to maximize value
  • Facilitate business merger or sale
  • Division of assets within a family and estate planning
  • Tax planning and other disputes
  • Litigation
  • Keep track of valuation for retirement

Valuating small businesses is tricky because there is no central database that keeps track of all transactions. Therefore, valuing a business requires a lot of work and information. Both business buyers and business sellers need to value businesses. The business seller usually has completed valuation and has a price. Regardless of the business seller’s price, the buyer must independently value the business as well. Usually the business buyer will value the business a price that is lower than the asking price. If the two valuations are in the zone of probable agreement (ZOPA) then there is room to negotiate and potentially close the deal.

Collecting this information for a business valuation starts from understanding the industry to conducting detailed financial analysis of the company’s financial statements. For industry analysis the evaluator must determine if the industry is growing or declining and how well the business is positioned within the industry. The evaluator must also complete competitive analysis using Porter’s five force analysis. Other elements of due – diligence includes quantifying the addressable market and current market share of the business.

There are several valuation methods one can use to determine the intrinsic value of a company. These valuation techniques are broadly classified as Asset value methods, Earnings value methods and Market Value based methods. The valuation methods listed above are based on discounting future cash flow, discounting future earnings and using industry specific multipliers. Corporate financial statements including the tax returns are the best source for intrinsic valuation and buyers should ask for at-least five years of data before valuing businesses.

Companies should enlist valuation experts for business valuation. Valuation experts can also help business owner’s benchmark against industry best practices and performance. Experts in business valuation fall in one of the following areas:

  • Business brokers
  • Certified appraisers and valuation experts
  • Forensic accountants
  • Attorneys and lawyers

Business owners tend to resist getting their business valued by a professional because of the cost involved. So, while it is important for business professionals to learn how to continuously value their business informally and they must also value their business formally.