As we discussed on the business pricing page, cash is king and the first thing the majority of business buyers want to know is what kind of income a business is producing for it's owner.
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. Business pricing for small and medium sized businesses is slightly different.
So how do we show true earnings for a private company? Seller's Discretionary Earnings, or DE, 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. We use the term sellers discretionary earnings or DE.
DE 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. OR All the items that discretionary items that your CPA puts on your tax to reduce your taxes - we add them back to the bottom line.
Non-recurring expenses: one time expenditures that are not expected to happen again.
How is DE calculated? This is done by recasting financial statements. This is why good financial records are essential. See financial Statements. 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 DE numbers are then averaged using a weighted average, the most recent being the most important and a DE number 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 DE.
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
This is a extremely simplified way to value a business. A formal valuation is a more accurate way to value a business and is recommended for most businesses. Business sales financed by SBA loans are now required to have a business valuation.
Once the DE 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 DE number. The multiple for small and medium sized businesses ranges from 1-7 times DE. Market data is often used to ascertain the appropriate multiple for a business. Excellent business pricing data is available.
For our clients, we use our proprietary database to pull business pricing market data from across Southern California and if needed from across the US to see what multiples similar businesses are commanding.
DE 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.
One final thought:
We hear from business owners all the time that say they have been contacted by a business broker or someone who is purporting to be one who tells them that he or she can "definitely" get them $X amount for their business. They spend no time on business pricing and try to list right away. They may also say that they have a buyer that is "ready to buy your business." It is impossible to know what a business is truly worth or how much someone is willing to pay for it without a thorough examination of the finances and a review of all the others factors that influence value. How can someone sell something when they do not know what it is worth?
If you are considering selling your business or would just like more information regarding business pricing, we would like to meet with you. We will perform the steps that we have just described above and develop a report that details an opinion of value.
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