What Is My Business Worth?

Determining the value of your business is probably one of the most difficult things you will be required to do as an entrepreneur.  The following information will provide you with valuable insight into business valuation and help you determine how your business will be valued. 

First some clarifications: EBITDA, earnings before interest, taxes, depreciation, and amortization is a common measure that publicly traded companies use to express earnings. Publicly traded companies want to show the highest earnings possible to please shareholders and Wall Street. This is quite different than privately owned companies. Business owners usually run as many expenses through their business as possible to reduce tax exposure. Also, EBITDA is not a good measure for privately owned companies since it does not include the owner's salary and any perks for the owner.

So how do we show true earnings for a private company? Seller's Discretionary Earnings, defined as: a measure of the total financial benefit accruing to the owner of a business. This is also called: cash flow, free cash flow, net cash flow, discretionary income, owner's benefit, net income, etc. - these terms, used in the context of business sales, all refer to the same value. This value is the amount that will flow to the new owner once the transaction is completed. Once the change in ownership is completed, the new owner will be able to determine where and how these funds are expended. Many in the industry use the term sellers’ discretionary earnings or SDE.

SDE (Seller's Discretionary Earnings)

SDE is comprised of: pre-tax earnings, depreciation, amortization, interest - PLUS owner's salary, owner’s perks, and non-recurring expenses. Let's take a closer look at the latter elements.

• Owner's salary: salary at fair market value for one owner.
• Owner's perks: cars, boats, homes, vacations, parties, gifts, life insurance, club memberships, tickets, salary to a non-working spouse or any item that the owner has personal discretion over.
• Non-recurring expenses: one time expenditures that are not expected to happen again.

Recasting:

How is SDE calculated? This is done by recasting financial statements. This is why good financial records are essential. Recasting is a process where the items listed above are "added back" to the bottom line. This is done by a professional business broker or a business valuation analyst. Once completed a buyer will have a more complete picture of the total benefit the business will provide for them. Ideally, the three most recent years of financial statements are recast. The three SDE numbers are then averaged using a weighted average; the most recent receiving the most weight.

Recasting is also done so that buyer can compare apple to apples when they are looking for a business to buy. If you look at business for sale websites, virtually all of the listings feature a cash flow figure. This figure refers to SDE.

An important side note: When recasting, it is important to be realistic in the calculations. IE: The company retreat could be considered discretionary. However, if this retreat has been happening for the last twenty years, and the employees view this free trip as a form of compensation, then it may be highly detrimental to add this back since the new owner will probably need to continue this event in the short term.

SDE Multiples and the Setting an Asking Price:

Once the SDE number is determined we can then move on to identifying a proper asking price. Most small and medium sized businesses will sell for a multiple of this SDE number. The multiple for small and medium sized businesses generally ranges from 1-4 times SDE (higher for larger companies with management structure, strong market presence, systems, and healthy earnings). Market data and comparables are often used to ascertain the appropriate multiple for a business.

Often in main street business sales, it doesn't matter what your business is worth on the books, or the value derived from an appraisal. Ultimately, the real value of your business is dependent on what someone is willing to pay for it. If a new owner can't afford to make payments to the bank or lender and earn a comparable living from the money the business produces; very few will buy it. When you look to determine a value of your business ask yourself, "How can I price this business so that a buyer can meet their needs?" In most cases, those needs are:

• To make the salary he hopes to earn or plans to pay an on-site manager
• To make payments to the bank to cover the cost of what needs to be borrowed
• To make a respectable return on investment on the 10-40 percent cash the new owner puts into the deal.

With a healthy economy, most buyers realize they could earn at least 8 percent a year just by putting their savings in various investment vehicles. Most hope to better that performance, with an investment return that covers the additional risk associated with buying a business. That may create problems for you the current business owner because you could be drawing below market salary or you don't pay any financing costs at all because you grew the company from inception without financing. Although most buyers look for a company with good growth prospects, they will price deals based upon prior financial performance.