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Valuing Your Business | Seller's Discretionary Earnings
When it's time to value your business it can quickly seem overwhelming.
It doesn't have to be!
There are a number of standard valuation methods that are used and in this episode, we'll go through one of them called 'Seller's Discretionary Earnings' or SDE.
We'll talk about:
1. What are Seller’s Discretionary Earnings?
2. When the Seller's Discretionary Earnings method should be used.
3. How SDE is calculated - with two examples.
4. Resources available to help you DIY.
Businesses are bought and sold based on the perception of future value.
Business owners are often experts in fields outside of business.
We developed Business BeyonDIY to help you cross that chasm.
Show Topics:
Buying a Business
Selling Your Business
Preparing Your Business for Sale
Practical | Actionable | Sustainable
Business owners and entrepreneurs are go-getters. We start things other people don't (sometimes too many things am I right?) and we push through hard times. That means that entrepreneurship involves a lot of DIY.
Some of the most important transactions we make are buying a business; preparing a business for sale and selling a business. We'll almost always want/need help to make these successful but there is still a lot we'll need to do ourselves.
Business BeyonDIY is a Livestream/podcast where we own our DIY nature but find that sweet spot where doing it yourself doesn't mean going it alone.
In this introductory episode, I'll let you know the format of the show, what to expect, and when I'll be live.
I'm looking forward to getting to know you and your business and sharing practical tips that will make your DIY more like DI-Us!
Stephen Krausse
We all want to get the best value when we sell our business. So how do we make that happen? I was considering buying a local business a number of years ago. And as part of the process, we needed to come up with an agreement on how much the business was worth, what the business was valued at. What valuation method made the most sense, and what would recognize a lifetime of work of personal investment on the part of this business owner. And in this case, it was the sellers discretionary earnings method. Hi, business owners and entrepreneurs Welcome to Business beyond the Iwai where we get you from here to what comes next. I'm your host, Stephen Krause II, I love business and I want to help you increase the value of your entrepreneurial journey. Business beyond DIY is about understanding and developing the value of business, your business. So let's get started. So the first thing that we want to talk about, sorry, I'm running a little late this morning, by the way, I Okay, so a little bit of a story, I am doing a project with my son on with one of my sons to do another business. And it's related to aquariums, which is not related to electronics or consulting. Super exciting for us. And eventually I'll talk more about it. But I was cleaning up a little water disaster, on top of which, as it turns out, we're having a little rainstorm, and there's so I was actually cleaning up water in one place. And there was water dripping. And I couldn't figure out what I had done wrong that water was dripping from the ceiling. Well, it turned out that because of the rain and snow, I have a roof leak. So okay, so that caused a little delay in the show this morning. I apologize for that. Anyway. So why do we care about what method of valuation we're going to use? Well, valuation determines the or it has a great impact on your exit, whether you're retiring, or you're you need seed money for your next venture, the valuation of your business is going to have an impact on that. And each valuation method tells a different story. You can have methods that are appropriate for high asset low profit businesses. And that might sound like a negative. But it's not necessarily true if you have a very stable business, but it requires a lot of equipment. And each widget that you sell is low profit. That's okay. That's a perfectly valid business model. In fact, it creates a high barrier to entry. So maybe the competitive landscape is is easier to deal with than some other cases. So there's value there, you might have a high asset, high asset, high profit, excuse me.
Business, you can have a low asset, low profit business. And that could still be viable. We talk about low asset or low profit, and we say okay, maybe that's not great. And maybe it's not great, but it might be valuable based on the considerations that you have in your business, you could have a low asset, high profit business, which is what kind of the holy grail if you can maintain market share. And that becomes difficult, because low asset means the barrier to entry could be pretty low. High profit makes an attractive market, which means that it's a really nice place to have. But it's also pretty neat for other people to want to be involved in so they can be coming to you for that. So how do we value each of these different kinds of businesses. And so there are different mechanisms that we use to value businesses and they are appropriate in different circumstances. Understanding the value of your business in each of the valuation methods, each of the scenarios that are appropriate is key to understanding and planning your best exit. The basic ways to evaluate to value a business are future earnings, asset value, and cash flow. Okay, we can wrap a whole lot of names around them, we can label them, we can have different. We can have specific cash, or specific valuation methods or calculations that are basically an iteration of one of these things. But at the end of the day, that's what they are. We're looking at future earnings, asset value, or cash flow. That's all we do not ever value based on revenue. And I've said that a million times I will say it every time I talk about business value, because it is so important. If somebody tells you that they want to value their business based on revenue, you don't have to argue with them, what you have to do is do your calculations based on something else. And if your calculations match, there's Coincidently, great. If not, then you need to enter that negotiation, understanding how you're going to adjust the revenue based model to a, what I would call a better model, a more a more accurate appraisal of the business value. So Alright, that's enough tirade about that. So the sellers, discretionary earnings is a measure of the cash flow that directly benefits the owner, and owner. And so let's talk and and it's one of the ways that we value businesses is common. And it's also and I want to say this now, and I'm going to keep saying it throughout this show, it is easy to do. Okay, there are a lot of accounting words and descriptions that we're going to have to talk about to get there. But at the end of this episode, I'm going to put up a spreadsheet, and I'm going to show you exactly how to value a business using sellers discretionary earnings and how easy it really is to do. Do not let people tell you that it is hard to do this, okay? Business Valuation is not rocket science. And anybody who tells you it is, is probably trying to ask you to pay for their services, and everybody should get paid. If you don't want to do the calculations or you don't feel comfortable doing them independently. There are a lot of good consultants out there who can help. And I'm not suggesting that they're trying to mislead you or anything like that in terms of it is important that it be done properly, but it is not hard to do. It may take a long time because you may have to dig through the financials, but it is not difficult. The calculations are not calculus. Okay. They are very simple. And that does not change. Let's talk about what is this specific ones sellers discretionary earnings or SDE, as you might hear it called according to the International Business Brokers Association, and I will have links to every resource that I talked about, among others. After the show, I will put them in the show notes on YouTube, as well as the podcast show notes if you're listening to this in the future on iTunes. Alright, so the earnings of a business enterprise prior to the following items, income taxes, non operating income and expenses, non recurring income and expenses, depreciation, amortization, interest, income or expense, one owner's entire compensation benefits and any non business or personal expenses paid by the business.
Wow. Okay. So we are going to drill into what all of that actually means. But let's talk about when it's used. No, actually, let's talk about what all of that actually means first, and then we'll talk about when it's used. What that actually means is, what is what does the seller have control over? What cash does the seller have control over, that you as the buyer will acquire when you buy the business? The sellers discretionary earnings are the sellers earnings, plus some additional things that we are going to talk about in detail. And it basically just means what is the cash that you control as the owner. In order to get that what you're going to see when you do this work is that it is you take the profit and loss statement. And you use it to calculate what is called EBIT da which is earnings before taxes, interest, depreciation and amortization. Big accounting word I get it. I will have a link to Investopedia his definition of this but it is basically just that it's the earnings before you account for Interest, Taxes, Depreciation and amortization. And we're going to talk about each of those in the detail that we need to so that you understand why they're part of the sellers, sellers discretionary earnings calculation, then we add back a few other items to come up with the business valuation number or the I mean the SDE, which we will use to value the business expenses that are added back our owner's direct compensation
payments that direct directly benefited the owner, this might be a bit of bonus or something like that travel that is not expressly business, one time expenses that are not recurring, so legal expenses, etc. Interest in income, which we will talk about, and taxes, taxes, amortization and depreciation. When do we use this method of finding out what cash the owner had control over as the method for valuing a business, we do it when a business is established. And it has a track record that you can point to, that we believe is stable that we can make the argument is it is stable, or relatively stable in terms of a revenue model. And it's also going to assume, and this is a big assumption, and you have to be comfortable as the buyer that the past cash flow is representative of future cash flow. So the same circumstances will exist with you buying the company as exist with the current ownership, for example, the economic environment is going to be similar for that product and service that the market need is going to be similar. Generally, the other piece of the when it's used equation is when you have a single owner, I want to point out that if you have multiple owners, you can still use this calculation, but you have to incorporate the operating agreement or partnership agreement into the calculation so that you understand the impact of that agreement on the partner that whose portion of the company you want to buy, how their partnership portion is valued. And that becomes a little more complicated. And this may or may not be the best valuation method, when you're looking at a specific partners shares. We talked a little bit about the owners control of cash, and what that looks like. So let's talk more specifically about those, those pieces. So we take the the EBIT, da number that I talked about before the earnings before taxes, interest, depreciation, and amortization. And we add back additional items. And and I guess I should stop. And I just want to remind you that I am going to go through a spreadsheet that I've developed and show you exactly how this goes together in just a few minutes, I just want to cover a few more of the basics of what you're going to see on that spreadsheet. And then we'll go through that. So you get a really good idea of what this looks like. Alright, if you're listening to the podcast episode, I am going to make this spreadsheet available as a template or as a download. So that link should be on the podcast notes. By the time you are listening to this. So you can go through and you can follow along with what I'm saying at a later time. Or I will link the video in the podcast show notes so that when you get to a place if you're listening in the gym or in the car or whatever, and you get to a place where you want to see the video version of this, I will link that in the show notes as well. Alright, we've gotten our EBIT da number, we're going to add back the owners compensation. Like I said before, payments directly benefited the owner personal travel that might have been paid by the company one time expenses, we will talk about these, I listed a few examples legal web design, product development. And I guess let's just talk about this. Now. Product Development is one that is listed as something if you do research on this, you're going to find product development comes up as something that you would add back meaning that the cost of product development is a one time cost. In my opinion, I almost don't care what what industry you're in what company you're doing, what product or service you provide, product development is always going to be part of what you do if you want to stay relevant and competitive. I don't see product development as a one time expense. If it's a one time expense, you are buying a product line, not a business. And there's nothing wrong with that, as long as you understand what you're doing. Okay, that's a critical differentiation and buying a product line is totally legitimate. But you have to understand that that's what you're doing product development, not really a one time expense, in my opinion, for most businesses, and the key there is just to analyze the business and say, am I going to have to change the product to accommodate a future world? Or am I going to need to change my service to accommodate a future world? And the answer to that is almost universally Yes. If you want to be competitive, you're going to need to update and innovate all the time. So it's always going to be an expense. It's always going to be something you have to deal with. Alright, interesting expenses and income. So this one is earlier I said this was about the cash you can control? Well, interest is something you can't control, we don't control the interest rate. In fact, today or yesterday, the Fed changed the interest rate, I didn't have any control over that. So it changes how much money costs when I need to borrow it, and it changes to a tiny, tiny degree, how much the bank is going to give me when I store my money with them.
So what we do is we remove from the calculation, any money we get from the bank, and we add back in the calculation, any money that we pay the bank. And what this is supposed to do is normalize the cost of money. This is one of those things that you have to be really careful about too, because it assumes that you're not transferring debt. If you're transferring debt, or you basically if you're going to assume debt that is owned by the business, or refinance the debt, then that money is going to be a real expense for as long as that debt is going to be serviced. And you need to account for that, whether you account for in this calculation or somewhere else in the negotiations. Totally up to you. But don't forget about it. Don't just say, Oh, well, we don't incorporate interest expense into this. Well, if you're borrowing $400,000, and that is to refinance AN EXISTING LOAN, you're probably going to want that interest expense to be part of your calculations. If you're borrowing money to buy the business, that's a different calculation, that's a different number. Okay, that's not something that the owner is going to incorporate into their valuation. It's something that you're going to consider as a buyer, as you go to look for how am I going to finance this deal? Okay. So the interest needs to become neutralized, because we don't have control over that. That's the basics. Taxes, well, taxes are only paid on money you make. So when we give the taxes back, we put them back into the pool of cash, because before we paid the tax, it was money that was in the business. And we could have used that money to invest in new equipment, we could have used that money to bonus the employees, we could have hired a new employee, we could have done product research or product development, we could have bought a new copy machine, whatever it is, that we could have used to advance the business, and those expenses would have lowered our overall tax burden. Okay, so taxes get added back. And because you have control over that cash until you pay it in taxes, amortization and depreciation are the last pieces of the EBIT calculation. Amortization is the expense of non tangible or intangible assets. So let's pretend we have a patent patents generally lasts for 17 years in the United States. And for simplicity sake, we're going to value that patent at $17,000. And so for example, I'm not an accountant. So disclaimer, talk to your accountant about how amortization might work in your specific situation. But for the purposes of a simple example, we're going to amortize the value of that patent over 17 years, and we're going to expense $1,000 a year until that value is zero, that money isn't cash. It's simply a non cash expense that's put into our p&l statement, our profit and loss statement or income statement. And it's so it's an accounting tool. And since it's not cash based, we add that back into the value of the business. And the same thing really goes for depreciation as well. Depreciation is the same basic function but for a physical good like a piece of equipment, a mill or a high end computer might be a an asset, that would be depreciated for video production company. And we do the same thing we say what is the expected lifetime of this asset of this piece of equipment, and then we decrement that overtime until the useful lifetime is expensed is fully expensed. And we call that fully depreciated. And that is again not a cash expense. So it goes back into the pool or into the value of the business. Alright, so that is a lot of words. I get it. There's a lot of accounting jargon in there. You know, if you get to the point where you're going to value a business and you need to sit down with your accountant and talk about what do these things really mean? That That's okay. But you can do these calculations without knowing what any of them been. And there's no I'm not saying you should go to the table with that with
without a basic understanding of those things, but you can do the calculations without it. So let's talk about this more specifically using this handy dandy spreadsheet that I made, which I have Windows completely covering here, move these around. Alright, so this is the spreadsheet that I'm going to add to a download link. And I'll clean it up a little bit. But this is going to help you understand and be able to literally calculate this for your own business. And I will actually be updating this with each valuation method calculation as we go through this series of episodes, where I talk about how do we value businesses, because again, this is not hard to do. It's intimidating if you haven't done it. And so I'm going to give you the opportunity to see it done. Do it yourself, pull your p&l for the last couple years, and run it see what your business is valued at based on this calculation. Right. So we take our p&l statement, right here, we're going to look at net revenue. And in this case, we're just doing the last five years, the last complete five years. So 2017 through 2021. And we're going to take the net revenue, and that becomes our baseline. And there are six numbers that come straight off of the p&l statement, don't have to do any work to get them, you just pull the p&l, and you add the net revenue, the interest income as a negative number, the interest expense as a positive number, the taxes, depreciation and amortization. So the only number that you put in as a negative is interest income. And if I were doing this spreadsheet, just to do the calculation, I would make that I would change the calculation below to incorporate that as a negative. In this case, I added it as a negative number, even though on the income statement, it's a positive number, just for visual example. So that you're very clear, when you look at this, how that number gets filled in, when you do the work. Alright, so all of these numbers come straight off the income statement. With the addition of instead of being a positive number in the interest income, it becomes a negative number. And we talked about why. So now the other piece to remember, if you're getting confused about the interest, don't worry about it too much. Because chances are interest income is not going to be a huge piece of the calculation, you can see in the case of this example, and for those of you listening to the podcast, it's $25 a year. And, you know, I, I don't know how much money you have in the bank. But you know how much interest you make on that money is probably not going to change the value of your business substantially. But we put it there for transparency sake. The last four items, which I've highlighted in yellow on the spreadsheet are the the other items that we add back one time expenses, owner's direct compensation, okay, the owner's direct compensation, I've kind of broken down into the direct compensation itself, and then potentially travel or personal expenses that were paid by the company that could be argued, are not a company related. So they were a benefit to the owner, and not necessarily to the business. I'll be honest with you this this kind of thing, your accounts probably going to ask you about any way. And they are going to say this is not really a business expense. And they'll find a way to account for it properly in the year that it's done. But they'll probably ask you not to pay for your trip to Disney World with your company credit card. Because commingling funds like that makes it difficult for your accountant to do their job. And it makes it difficult to see where your personal life and your business life separate. And that matters. So we got to be careful about that. Putting this spreadsheet together, and again, if you're looking at if you're listening to this episode, all we did was take the numbers off the p&l Fill in the first six line items. And then for the one time expenses, you are going to have to dig into those financials and say, Oh yeah, I did a contract that required legal work. That was a one time expensive. Maybe I had my a lawyer do the terms and service for my website. That's a one time expense maybe. Or I did a web design for 2022 and I paid for it in 2021 So
that needs to get expensed. Or maybe there were licensing fees that I needed to pay something that's only going to happen one time. That won't impact the buyers experience. When they own the business, because they're going to they're they will have bought that when they buy the company. Owners direct compensation is kind of easy, although you do have to pull it. Now, the compensation, if you're thinking this through, you're saying, Okay, I've got my gross profit, which is just your your revenue minus your cost of goods. And then in your Payroll Expense, you're going to have removed the salary for your, your owner, we have to add that back, because it was registered as an expense, but it is a value that the owner has. So we added back into the calculation. In this case, we added it back at $60,000 a year just as an example. We said, okay, there were this particular owner went to some conferences in 2017, through 2019. And they spent $3,500, on personal vacations during that conference. Then in 2020, and 2021, they didn't travel because of COVID-19, for example, and so those those were zero, and then we had $200 a year for personal expenses, I don't know what that would be, that wouldn't be accounted for differently by your accountant, so but you can, you need to understand that from your accountant. So if the company's paying for something that is not benefiting the company, you're not going to get to, to call that an expense, you're going to have to add it back in as an owner benefit. Let's let's talk a little bit about how we get those numbers. So you're going to take the the income and expense sheet, and I've done this annually, the income statements annually for the five years that I've put in my example. And you may need to go month to month and go through each expense and decide oh, yeah, the legal expenses in February, were higher than usual, because I had this terms of service that I had my lawyer do. So you may have to do some work to make sure you get the those accurately because I can tell you what, if you're going to use this valuation method, and I'm on the buying side, I'm going to be looking at that. Because I want to understand what you're claiming. And you want to understand the benefit that your company provided to you as an owner if you're trying to produce a selling price. So some of this actually benefits you tremendously. If you can add it back. Now, if you're adding back having your landscaping done as your house, that that's good for your valuation, because it was money that the owner had control over. But your accountant is probably going to have a conversation with you about how you want to pay for that in the future. In the in the case of this first example, if you look at the average net revenue for this business is $55,400. Okay, if you look at the sellers, discretionary earnings calculation for that, it's more than twice that at $132,459. So you can see right away, that done properly, this can tremendously change the value of your business. I did a few examples of valuation examples where we looked at 4x 6x and 10x, that value, which are you know, just examples of where someone's going to say, Okay, in this industry for X SDE, or four times S D is a good business valuation based on the market for that business. So, in this case, it would have been $529,000 at 4x 794,006x and 1.3 million at 10x. Those are based on the industry, generally speaking, and negotiation. Of course, that kind of gives you an idea of how dramatic the difference can be between looking at net revenue, or I'm sorry, yeah, net revenue, or net income I should actually hold on. This should be net income, not net revenue. All right. So your net income at 55,000 versus your SDE at 132,000. It makes a big difference in the valuation of your business. So that's important.
Alright, let's look at another example. And in this case, well in this first example is kind of a business is sort of static You know, we went, it's got an average of 55,000. In net income per year, and it goes from, you know, 50 to 5557 47, and 68. For each of the years, it's this pretty stable. It's not bad, nothing to write home about, really in terms of growth. But you know, a, but it's a stable business. So that's a good example, where SDE might be a good valuation method. So let's look at a declining business. I like to talk about these because people don't always understand that a declining business can have positive value. So if you look at this, and and for audio listeners, we're looking at a business where net income was negative 6000. So a net loss of $6,000 in 2017, zero, so just breakeven in 2018 $24,000 of profit in 2019, between a $35,000 loss in 2020, and a $13,000. loss in 2021. Okay, so that makes an average of $6,000 loss per year, and you would assume, okay, there is no value for this business. You're gonna have to pay me to take it. Okay. But wait, is that true? If you run the SDE calculation, you can say you can get real numbers off of real financials, and say, Wait a minute, it's actually worth the the SDE for this business is $60,000 a year. Now that's mostly owner salary. Because I mean, it doesn't take a rocket scientist to say okay, if they're making $60,000 a year, and the value is $60,000 a year. That's it. But what it says is that there's value there that you can sell. So loss after loss after loss after loss is not something that doesn't have value. And that's not what this episode is about. But I do want to touch on that because and I will do some episodes eventually about how to handle a declining business. Because it really is, just because a business is in decline or hasn't performed like you want it to doesn't mean it has no value. And it is okay. And I've talked about this before, it is okay to say I'm not the person to take this company to the next place. I'm not the person. Okay? That doesn't mean it doesn't have value, find somebody who does see a way to move it forward. And then you extract value from the business by turning it over to somebody who can get more value because they have a way of leveraging it in a way that you couldn't and they get value. So that's I just want to touch on that the point of for this exercise is to understand that you can see the value of this business compared to the other one, roughly speaking between 241,600 1000 Based on the the four times SDE, six times SDE, and 10 times SD, the business valuation spreadsheet, like I said, this is going to be up on my website or available as a download. And let's go back to the camera and we'll go and get back to my notes. So what I want you to walk away with here is that this calculation, there are a lot of accounting words that people are going to say, they're going to say SDE, they're going to say EBIT da, they're going to say depreciation, amortization, interest, expense, interest, income, blah, blah, blah, blah, blah. When you go to calculate this number, though, all you have to do is pull items from your income statement and put it in a spreadsheet, whether you download my spreadsheet and use that as your example. Or you make your own spreadsheet. That's fine. But you just plug and play those numbers. And like I said, in the case of some of those added items, like owners compensation and travel and one time expenses, you are going to have to dig through your business and find those. But I will I imagine that you can get 80% of those just by thinking through your business for that year. What did I do this year? Oh, I did a new website. But that's not something I do all the time. So it's probably a one time expense. Oh, I
got those terms of service done by my lawyer. Oh, I had a hiring expense because I needed a recruiter to hire a specific position and I didn't have the time or the skills or whatever, to make that acquisition myself without hire myself. So I had a one time expense for that. Those things get added back in. So you just go through your year what was beneficial to you? What did you do? Or not? What was beneficial to you? What action did you take that you can remember? And you add that in, someone else is going to come back to you and say, what about this? Is this a one time expense? Or is this not a one time expense, if I were coming back to you, I would say product development is not a one time expense. And I would want I would want that removed from the SDE, because I don't believe it, like I talked about before. So that becomes part of the negotiation process. But you can come up with those things just by going through your year, and see what I do this year that I don't do every year, you know, and you can look at the the expenses on your p&l for the month and go on a month by month basis, and I get it. When you're talking about five years, you know, and 12 months, you've got 60 months, you've got to go through and find anomalies. What doesn't make sense. And the best way that I've found to do that is put all the months on one spreadsheet. And then you can just compare the lines and say, oh, yeah, this was 4540 540-545-6000. Okay, what did you do on the month? That was 6000? Is that a one time expense? All right, that is sellers, discretionary earnings, it is a common way to value a company. And it's something that is important to know, I suggest that you actually always value your business based on every valuation method, so that you know where a buyer might be coming from, or where you as a seller might want to approach a buyer. When you're going into negotiations. Do I want to be a seller? Or do I want to do it with SDE? Do I want to do an asset value do I want to do it some other mechanism? Those, if you have calculated it already, nothing surprises you. You know what they're going to come up with when they use your financials to come up with a number. And so you can figure out how to approach it so that you get the most for your business. And if you're the buyer, you know how to approach it so that you can have an appropriate valuation for where you see the company going, and how you want to approach that business. Alright, so thank you so much for joining me on this entrepreneurial journey this morning. I'm Steven Crowder with beyond 50% and I help entrepreneurs buy and sell businesses with experience driven process and impartial analysis. Connect with me on one of the social platforms listed in the description below. Or if you're if you're watching on YouTube, or if you're in the shownotes if you're listening to the podcast episode, you'll also find a link to book some time with me to discuss how I can help you buy a business or sell a business or prepare your business for sale. If you found this video helpful, like everybody else, please like and subscribe. That didn't come out. Right. All right. If you found this video helpful, what I meant was like everyone else is going to ask you if you found this video helpful, like and subscribe to the video to the YouTube channel. If you're listening to the podcast and this provided you value, please let the podcasters know by providing a five star review that lets other people know that this podcast exists and that it has relevant content. Thank you again. Remember that doing it yourself, doesn't mean going it alone. And I'll see you next week.
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