What is my business worth?
This is a common question from small-business owners considering selling a business. The basis of all business valuations revolves around two terms: SDE and EBITDA.
SDE = seller’s discretionary earnings
EBITDA= earnings before interest, taxes, depreciation and amortization
How are SDE and EBITDA calculated, and what is the difference?
SDE is the total cash created by the operations of the business for the owner – basically, the amount of money the business creates that is “at the discretion” of the business owner. “At the discretion” means once all the business expenses are paid, the owner can use the leftover cash in any way he or she chooses.
Clearly, SDE is a very important figure to a business owner as well as to anyone considering purchasing the business.
The SDE is the key to several questions for the prospective buyer:
• Does the business make enough money to support the owner’s/buyer’s lifestyle?
• After lifestyle needs are met, is there any money left over to pay back a lender if money was borrowed to purchase equipment or buy the business?
• After lifestyle and paying off debt, is there any money left to grow the business?
Believe it or not, paying your salary, debt costs, and investing to grow the business are all considered discretionary expenses.
Once the SDE of the business is known, EBITDA can easily be calculated.
EBITDA is SDE minus the amount an investor would need to pay a professional manager to run the business.
Investors acquiring a business may not want to operate the business day-to-day; instead they hire a manager to run the business’s daily operations under the supervision of the investors. The cost of the manager, including benefits, is subtracted from the SDE to determine EBITDA. Because the cost of the manager is a discretionary expense, removing that cost to determine the EBITDA value is used by investors as a benchmark to determine return on investment (ROI) or as a comparison between businesses.
SDE is generally a term that is used in owner-operated businesses. EBITDA can also be used in owner-operated businesses, but the businesses tend to be larger. Larger businesses attract the interest of investors because of the industry or other opportunities investors may perceive to increase ROI, and EBITDA is a good benchmark.
Finally, the market value of the business is determined by applying a “multiple” to either SDE or EBITDA.
The appropriate amount of the multiple is determined through a business broker’s research, based largely on similar business sales and the multiples paid by buyers.
Owner-operated businesses using SDE as the basis of the calculation of value typically bring multiples ranging between 1 and 4 times SDE. Note: To sell in the range of four times SDE, the business must offer some special strategic value to the buyer.
Businesses with value based on EBITDA generally have multiples ranging between 3 and 5 times EBITDA. Even higher multiples have been paid for strategic acquisitions and those in high-growth industries where investors see vast potential.
As a business owner, the more you understand about the cash your business generates, the better handle you have on business value. Working with a professional business broker/M&A adviser with knowledge of the markets, experience owning and selling businesses, and the wisdom to provide sound advice is key to analyzing your business’s value.