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.

Business Buyer Checklist

Determine Baseline Deal Structure

The buyer should determine his budget and come up with a baseline deal structure prior to shopping for a business. There are several elements that constitute a deal including cash at closing, seller financing, mezzanine financing, seller retained equity, and earn-out.

Cash at close is the actual cash that will be transferred from the business buyer to the business seller when the deal closes. Seller financing is a loan provided by the business seller to the business buyer. Mezzanine financing is a hybrid between debt (loan) and equity financing. It is a variation of debt financing where the lender has the right (option) to convert the loan to an equity interest if the company defaults on the loan. As the name suggests, Seller Retained Equity is the equity retained by the seller in the business after the owner (management) of the business changes. Once a business buyer has determined the baseline deal structure and cash on close amount he should get approved for financing before approaching a business broker or business seller.

Complete Financing

It is getting harder and harder to get credit in the current environment. Therefore most business brokers and businesses sellers require the business buyer to verify their ability to purchase a business before getting into lengthy due-diligence process.  The buyer should be clear on what the sources of financing are.  The average first time buyer is an experienced professional in the mid 40’s, so a large portion of financing may come from personal savings or home-equity. Additionally, the buyer should be clear on how much of his funds he can use for down payment. In some cases there may be an option to ask for seller financing. The buyer should be clear on the terms for seller financing before approaching the seller.

Build a Team

Purchasing a business is a complex transaction, so the business buyer should engage a business broker to assist him with the process. TheBuySellBusinessess.com website can help buyers and sellers connect, but businesses then need to engage a broker to complete the transaction. In addition to business brokers the buyer may also need to engage an attorney to evaluate the term sheet, stock purchase agreement, leases, franchise agreements etc. The buyer should engage an accountant to review the books for structure the business deal.

Business Assets

Typically, purchasing a business implies purchasing the operating assets only. That said purchasing a business can be extended to include the corporation and fixed assets. In some cases buyers may not want to purchase account receivables (AR). The buying party can include or exclude any assets in the agreement. The buyer should know upfront the industry he wants to focus and if he is in the market to buy an operating business or to buy an operating business with fixed assets.

Find a Business

There are many sources buyers can use to find a business. http://www.buysellbusinesses.com/ and similar Websites are one source. Business brokers play a crucial role in finding businesses as well.

Using Rules of Thumb for Business Valuation

Discounted free cash flow (DCF) and earnings excess based valuation techniques are the fundamental to correctly valuing businesses. That said businesses can also use rules of thumb to quickly value their businesses. Using rules of thumb is a great approach to get a quick and dirty estimate before conducting deeper financial analysis.

Rule-of-thumb valuation is a guideline that businesses owners and business brokers use for a particular industry or line of business to value a company. There are rules available for almost every type and size of business in existence. Most of these rules are based upon multiples of an economic benefit such as earnings, cash flow or annual revenue. Check with your industry associations for rule of thumb formulas for buying or selling a business.

Some examples of rules-of-thumb used to value businesses are:

  • Accounting firms are valued at 100-125% of annual revenue
  • Dry Cleaners are valued 2-3 times adjusted cash-flow or 70%-100% of annual revenue
  • Gourmet coffee shops are valued at  40% of annual sales + inventory
  • Food shops are valued at 30% of annual sales + inventory
  • Gas Stations (w/o C-Store) are valued at 15–20% of annual sales + inventory
  • Law Practices are valued at 90–100% of annuals revenues
  • Restaurants (Full-Serve) are valued at 30–35% of annuals sales + inventory
  • Insurance Agencies are valued at 125–150% of annual revenues
  • Grocery Store (Supermarket) are valued at 15% of annuals sales + inventory

Business for Sale Checklist

Gather Information for Business Valuation

Business brokers and sophisticated business buyers may use intrinsic valuation techniques for business valuation. They will project the free cash flow (FCF) from the business for the next few years and discount the cash flow projections to determine the intrinsic value. Additionally, business buyers will also try and estimate the value of a business by looking at values of similar businesses sold locally.

Selling a business is complex and the seller must take the time to plan and organize the exit. To assist with valuation and eventual sale, businesses need the following information.

  • Balance sheet, income statement and cash flow statement for 3 to 5 years
  • Corporate tax returns for 3 to 5 years
  • Value of inventory
  • List of capital expenses on fixtures and equipment
  • Customer and contact lists (Customer of Contact Management System)
  • List of employees
  • Copies of all leases, franchise agreements (if applicable)

Is Canada more entrepreneurial than the US?

As per census.gov there are approximately 27 million businesses in the US in 2008. However, more than 21 million forms are non-employer firms. Approximately 6 million firms are employer firms. Of these only 18 firms have more than 500 employees, which is negligible. So we can conclude there are 6 million businesses with 1 to 499 employees and 2.5 million businesses with 5 to 499 employees in the US.

As per statscan, in December 2012, Canada had 1.2 million small businesses with 1 to 499 employees on payroll. Similar to the US, approximately 50% of the workforce is employed by small business. Canada is approximately 10% of US population, so one would expect Canada to have 600 thousand small businesses. With 1.2 million small employer firms, Canada may be twice as entrepreneurial as the US. That said this analysis is purely qualitative and does not take into account the quality and size of the average business. The results are also surprising given the fact that US leads Canada significantly in the ease of doing business report compiled by the World Bank.

Inspirational Business Quotes

Quote

In an interview Thomas Edison said, “None of my inventions came by accident. I see a worthwhile need to be met and I make trial after trial until it comes. What it boils down to is one per cent inspiration and ninety-nine per cent perspiration.

The same idea as quoted by Steve Jobs.

You know, one of the things that really hurt Apple was after I left John Sculley got a very serious disease. It’s the disease of thinking that a really great idea is 90% of the work. And if you just tell all these other people “here’s this great idea,” then of course they can go off and make it happen.

And the problem with that is that there’s just a tremendous amount of craftsmanship in between a great idea and a great product. And as you evolve that great idea, it changes and grows. It never comes out like it starts because you learn a lot more as you get into the subtleties of it. And you also find there are tremendous trade-offs that you have to make. There are just certain things you can’t make electrons do. There are certain things you can’t make plastic do or glass do. Or factories do. Or robots do.

Designing a product is keeping five thousand things in your brain and fitting them all together in new and different ways to get what you want. And every day you discover something new that is a new problem or a new opportunity to fit these things together a little differently.

And it’s that process that is the magic.—Steve Jobs