Every business owner wonders what their business is worth. Of course, a business is worth what a buyer is willing to pay for it, just as is the case with a share of stock, a painting or a house. In the case of Main Street businesses, the key factors that determine what a buyer is willing to pay are the following:
- Seller's Discretionary Earnings (SDE).
- Terms of the Sale.
Seller's Discretionary Earnings
The main factor of determining value of Main Street businesses is the total cash flow benefiting the owner - also known as Seller's Discretionary Earnings (SDE). SDE is calculated using the following six categories:
- Profit or loss as reported.
- Owner's Salary.
- Discretionary Expenses.
- Non-recurring Expenses.
- Non-cash Expenses.
- Expenses not included in the P&L.
Once theses categories are added together and an SDE is developed, a multiplier is applied. The multiplier can range from 1 to 5 (or more), depending on many factors, to arrive at the appropriate value for the business.
The second valuation factor is the level of risk. Factors in this category include:
- Years in business and with the current owner.
- Profit trend.
- Quality of books and records.
- Franchise membership.
- Brand recognition/ strength.
- Level of competition.
- Dependence on current owner.
- Diversification of customer base.
- Lease length and terms.
- Asset value.
Terms of the Sale
This is the one source of value that the business seller can almost completely control. Components of the terms include:
- Down payment.
- Interest rate.
- Monthly payment.
- Non-compete agreement.
- Seller training of buyer.
The majority of sales include the seller to provide some level of financing to the buyer of the business. With seller financing, the seller receives part of the purchase price at the time of the sale ("the down payment") and the remainder over several years. The buyer uses the cash flow from the business to pay off the debt. Structuring a sale with attractive terms can significantly increase the value of a business.
Certain businesses are valued at five (or more) times the seller's discretionary earnings while other businesses only bring 1 at a time. An important reason in determining the multiple of SDE is the industry of the business. Certain industries are more desirable than others. Factors influencing desirability include:
- The fun and ease of operating the business.
- Employee relations.
- Operating hours.
- Growth potential.
In the case of larger mid-market companies, Seller’s Discretionary Earnings (SDE) are usually replaced by another cash flow measure, Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Future growth potential and projected earnings play a more prominent role in valuations compared to smaller businesses. The other factors – Risk, Transaction Terms, Industry – remain very important regardless of size.