How-To Guide: Business Valuation – Part 2

Value vs Price

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By Steve Whitehill

In our prior article we discussed different valuation methods. Each of the valuation methods has its strengths and weaknesses. Generally speaking, for main street and lower middle market businesses, we use the valuation based on earnings. While these earnings have many different names, we then to use either SDE or Owner Benefit. I happen to prefer Owner Benefit as it is more descriptive.

To value a business, follow these steps.

Step 1: Determine the seller’s discretionary earnings (SDE)

This step is essential for valuing small businesses as it formulates a reliable estimate. It gives you a clear indication of the company’s actual profit after costs. SDE is income your business makes before tax, owner salary, non-cash expenses, interest, and one-time purchases. To calculate Owner Benefit or SDE we start with the profit of the business. For our purposes we start with EBITDA – Earnings Before Interest, Taxes, Depreciation, and Amortization. Then we add certain items back. What we add back are items that are of benefit to the owner. They include such items as: Owner’s Salary, Provable Cash (frankly if you are not paying taxes on it no one is paying you for it), personal expenses such as non-business automobile, travel & entrainment, insurance and other personal expenses. We also deduct non-working employees (family members – paying your 5-year-old $100k per year) over-payment of friends and family (paying your wife $200k for a $50k Bookkeeping job).  Then we adjust rent for property you own that the business is in. For example, it is not uncommon for an owner to either not pay rent on their property, or over- or under-pay rent. We make the appropriate adjustment. Then we make adjustments for family members that are under-paid. Lastly, to determine SDE we adjust for any other personal expenses paid for by the business.

Step 2: Identify your SDE multiplier

For most main street and lower middle market businesses the SDE Multiplier is typically somewhere between 1 and 4 (although sometimes higher). Some of the factors that will affect the final selling price include industry, size of the company, assets, and risk. For example, if a business is selling in a dying market, the SDE multiplier will be negatively affected. If the business is selling in a booming market, the SDE will be positively impacted. The SDE multiplier is determined by historical information and is calculated by dividing the Selling Price by SDE. Interestingly, this multiplier does not change significantly in good or bad times. The price you pay for a business does change because profitability changes under different economic circumstances. Size matters: as businesses get larger, the SDE multiplier goes up. Our Valuation Calculators make adjustments for this.

We are almost ready to determine the price of the business.

Step 3: Add assets

Think of this step like crossing your t’s and dotting your i’s. After you have determined the SDE, add the value certain asset, but not all assets. For example, tools of the trade are not usually added to value determined in step 2 above (SDE * industry multiple). An example of what is included, but is an add to the price, is inventory. This is usually the only item added.

Most businesses are sold as asset purchases. Thus, no liabilities go with the business (just the  assets are being sold) and must be paid by the seller at or prior to closing on the sale. This would include any amounts due or owed on the assets being transferred.

Other issues in determining value

Our more advanced calculator takes into account such factors as: Years in Business, Percent of Business that is Recurring, Total Number of Customers and how many customers account for a large precent of your revenue? To this mixture we add other factors such as:

  • What are your average Revenues/Sales growth rate per year for the past 3 years?
  • What is your average profit growth rate per year for the last 3 years?
  • You project growth over the next 3 years?

This information will help give us a better picture of your company.

Part 3 will focus on real world examples and show how the process works using our calculators.

Buying or selling your business? Maximize your deal by working directly with one of our experienced experts.