What Is My Business Worth? Learn How Small Businesses Are Priced
The first important concept that relates to business pricing is the concept that cash is king. Buyers acquire businesses for the income that they generate. Regardless of how glamorous a business is, at the end of the day buyers commit based on cash flow. Buyers move forward when the return on their investment makes financial sense.
So how does one arrive at a price when selling a business?
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. The value, that we are seeking, is he 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 these funds are expended. I use the term sellers discretionary earnings or SDE.
SDE is comprised of: pre-tax earnings, depreciation, amortization, interest - PLUS owner' s salary, owners 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.
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 being the most important and a SDE figure is arrived at.
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 ranges from 1-7 times SDE. Market data is often used to ascertain the appropriate multiple for a business.
For my clients, I will use our database to pull market data from across Southern California and if needed from across the US to see what multiples similar businesses are commanding.
SDE X Market data driven multiple = Asking Price. The asking price is then driven up or down based on additional factors such as intangible assets and risk.
About the Author
Ron Van Orden is a Business Broker practicing in Southern California and the creator and writer of http://www.California-Business-Broker.com an online resource dedicated to the buying and selling of small businesses. A Southern California native, Ron works with successful businesses throughout Los Angeles, Orange County, Riverside, San Bernardino and Ventura Counties.