As discussed in a previous blog, buyers will buy a business based on how much money the business will make for them.  The buyer will want the business to provide an acceptable rate of return on their down payment, pay them a salary, and cover payments on the money borrowed to finance the acquisition.  And they will want some cushion too.

Just as in valuing a property in real estate, there is more than one way to value a business. A business can be valued by applying a multiplier to its discretionary earnings. Discretionary earnings, also called seller’s discretionary earnings (SDE), represent the full benefit of ownership that the owner enjoys. The multiplier, or range of multipliers, is determined by market research of sales on similar businesses. A business value can also be derived using discounted cash flow, especially if the future cash flow is reasonably stable or predictable. A business will also have a value based on its assets, which include its furniture, fixtures & equipment (FF&E) along with its inventory.  This is considered to be a liquidation value. For this blog, we will focus on the SDE method.

Business valuations begin with review of the past 3 (5 in some cases) years of financials, particularly the Profit & Loss Statement. The SDE is calculated for each year. To calculate SDE, begin with the Gross Profit and add back expenses which are non-cash expenses, discretionary expenses, unique or non-recurring expenses, and expenses which are direct benefit to the owner. This is known as recasting the earnings, but it might be more appropriately called recasting the expenses.

Non-cash expenses are expenses in which no money actually leaves the business. These includes

  • Depreciation
  • Amortization

Discretionary expenses include any expenses that are an owner’s choice or are not critical to the operation of the business. Examples of discretionary expenses are:

  • Interest
  • Charitable donations
  • Dues and Subscriptions

Unique or non-recurring expenses are expenses that rarely occur, or, arise due to special circumstances.

Examples include:

  • Remodeling the facility
  • Regulatory fines

Owner benefits are transactions which are recorded as expenses, but are functionally benefits to the owner. These expenses include:

  • Compensation to Officers
  • All or part of owner’s salary
  • Owner life insurance policy
  • Owner 401k match
  • Owner health insurance
  • Cost of owner’s company vehicle in excess of vehicle which is necessary (Lamborghini vs Chevy)
  • Salaries paid to non-working family members (it happens)
  • Cost of vehicles provided to non-working family members
  • Dining expenses (non business)
  • Excessive travel
  • And many more

Once the recasting has been done and a 3-year history of SDEs has been derived, a weighted average can be calculated.  Typically, the most recent year will get the highest weight, but there can be circumstances that would point to a different weighting. This is another point that it pays to have a good business broker. After settling on the weighted average for the SDEs, a multiplier, or range of multipliers, should be researched. There are several good subscription web sites that log information about business sales. You can research sales of similar businesses (same NAICS code) and filter by area and date.  Applying these multipliers to the weighted average SDE results in a range of values. The more “ready to sell” a business is (discussed in previous blog), the higher in the range it will fall.

After the decision is made to sell a business, valuing it is likely the easiest step. If a business owner and their business broker agree on value, it’s time to take the business to market. Offering Memorandums and Offering Memorandum Summaries must be prepared. Marketing strategies must be developed. Buyers must be found and vetted for financial ability to buy and business acumen to succeed. The ones that are left must be convinced of the business’ value. Expect a long and detailed due diligence period that will seem intrusive at times. It will pay to have the right business broker to guide you through this process.