Evaluating Your Business In 3 Steps
Most experts agree that the starting point for valuing a small business is to normalize or recast the business’s earnings to get a number called the “Seller’s Discretionary Earnings (SDE).” SDE is the pre-tax earnings of your business before non-cash expenses, owner’s compensation, interest expense and income, or one-time expenses that aren’t expected to continue in the future.
Small businesses report expenses on their tax returns with an eye towards reducing their tax burden. This means you likely claim many deductions that lower your business income on your tax return. For this reason, using income numbers from a business’s tax return can underestimate how much revenue the business actually produces.
SDE gives you a better idea of the business’s true profit potential by calculating the what the business’s earnings would be with a new buyer. This is done by adding back in expenses listed on your tax return that aren’t necessary to run your business. This includes your salary as the business owner and any one-time expenses that aren’t expected to recur in the future.
Here are some examples of things that would be added back into the net income reported on your business’s tax return to calculate SDE:
- Your salary, or total salary of all owners
- Any perks you or other owners receive(like personal travel or personal vehicle payments)
- Family members on payroll holding non-essential positions
- Non-cash expenses such as depreciation and amortization
- Leisure activities, such as business golf outings
- Charitable donations
- Any personal expenses, like the purchase of a personal vehicle, that were noted as expenses on the business tax return
- Business travel that’s not essential to running the business
- One-time expenses that are unlikely to recur after the sale of the business, such as the settlement of a lawsuit
Businesses typically sell for somewhere between 1 and 4 times their SDE. This is called the “SDE multiple” or “multiplier.” Finding the right SDE multiple is really more of an art than a science because it varies based on:
- Geographic trends (market risk)
- Company size
- The business’ tangible and intangible assets
- Independence from the owner (owner risk)
- And many other variables.
Think of the industry standard multiplier and the specific business multiplier as two separate numbers, one giving you a general value based on industry averages and another giving you a more specific value based on variable factors of each individual business.
The biggest factors influencing the SDE multiple is usually owner risk and industry outlook. If the business is highly dependent on you or another owner, it cannot be easily transferred to new ownership and the business’ valuation will suffer. If you’re selling a business in an industry and/or area that is expected to grow in the near future, the SDE multiple will be higher.
Keep in mind, Shawn can help you evaluate your business directly, saving you much of the time and hassle.
The final step of how to value a business is to account for business assets and liabilities that aren’t already included in the SDE. Most small business sales take the legal structure of an “asset sale,” which means the purchaser is buying the tangible and intangible things that make the business what it is. Typically the seller retains liabilities, but deal terms will vary from sale to sale.
Tangible assets are physical goods owned by the business that you can put a value on. Some examples include real estate (if the business owns any property), accounts/receivables, and cash on hand. These are generally not included in the SDE multiple. All tangible assets should be added into the valuation separately (as shown in the examples below) if you are purchasing them.
Intangible assets are non-physical goods that have a value for a specific business purpose, like reputation, trademarks, patents, and goodwill. These assets are included in the SDE multiple, because they are typically only sold if your business’s assets are sold.
A business’s current liabilities are debt or other obligations the business has that it must pay for in the future. Many sales have been lost by sellers unwilling to keep the liabilities they created for the business.
An asset sale typically is structured where the seller pays off the business liabilities with proceeds from the sale. However, it gets more complicated when discussing things like an open line of credit facility that the business needs in order to continue operations.
One way to determine what the potential liabilities are for a business is to run a business information report through Dun & Bradstreet. This can be purchased on virtually any company, by anyone, for $121.99 and will give you information such as:
- Current debt
- How often the business currently pays their suppliers on time
- Any debt they’re past due on
It’s a cheap way to get information about the business or to confirm that you’re not missing any important liabilities. It’s important to note that this may not include all liabilities, but it should give you a good estimate.
Final Business Valuation Formula
Now you can distribute all of your balance sheet lines into the appropriate category and use the formula below to come to an estimated business value:
Business’s Estimated Value =
(SDE) * (Industry Multiple) + (Real Estate) + (Accounts Receivable) + (Cash on Hand) + (Other Assets Not in SDE or Multiplier) – (Business Liabilities)