Valuing a business seems like a simple task, but there are actually many different methods of determining worth. When using these methods, it’s important to understand why the size of the business matters. Our Texas business valuations are customized to your company, so no two valuations are alike. Let’s breakdown the different styles and methods of business appraisal and valuation – get ready for some alphabet soup.
The Basics of Texas Business Valuation
The first step in business valuation is understanding the differences between “M&A Style” valuations based on EBITDA/DCF approach vs. “Main Street” valuations based on SDE/bankability approaches. Let’s unpack the most common ones:
– Multiple of EBIT (Earnings Before Interest and Taxes): net profit plus interest and income taxes, multiplied by 2-6 times or more depending on the industry
– Multiple of EBITDA (EBIT plus Depreciation and Amortization): net profit plus interest, income taxes, depreciation and amortization, multiplied by 2-6 times or more depending on the industry
– DCF (Discounted Cash Flow): an approach that estimates the total value of all future cash flows, then discounting them to find the present value of that cash. In layman’s terms: an estimate of the amount of money received from an investment, decreased by the time value of money which assumes a dollar today is worth more than a dollar at some point in the future.
The above three approaches are most common among academics and investment bankers. They apply to companies that are well-established, with professional management who typically are not the owners. Companies of this size are typically bringing in over $1 million in EBITDA every year. Buyers are typically private equity groups or larger companies in a similar industry (many large companies have mergers and acquisitions departments dedicated to acquiring mid-sized companies). These buyers have access to premium financing options, often lines of credit or term loans, with life insurance companies that have low-interest rates and long repayment periods.
Small Business Valuation
Since these approaches are well-documented and sales of larger companies often make the news (especially when they go public and stock prices are announced), owners of smaller businesses don’t know of any other ways to value their businesses. However, the market for smaller businesses (aka “main street” businesses) under $1 million in EBITDA follows a different set of rules with a different set of metrics. This is because the sellers of these types of businesses are typically owner-operators (the business is not managed by a CEO who reports to the owners) and buyers of these types of businesses have to rely on conventional financing (often SBA-guaranteed loans that have higher interest rates and shorter repayment periods). As a result, the multiples are smaller, and the mechanics to measure cash flow are different. The most common approach here is multiple of SDE. Let’s break it down:
– Multiple of SDE (Seller’s Discretionary Earnings): Instead of EBIT or EBITDA, in closely-held main street businesses, the reported earnings of small businesses may include deductions for the owner’s salary and other perquisites. Therefore, we use SDE as a better measure of the earnings of a small business than the reported income. It is defined as net income before deducting owner’s compensation and benefits, and other discretionary, non-operating, or non-recurring income or expense, depreciation, interest, and income taxes. This is typically multiplied by 2-3 times for main street businesses (not 2-6 times EBITDA for larger companies).
100% owners of main street business can decide to pay themselves as much (or as little) of a salary as they desire, and their CPAs often advise them to make large capital improvements that may not be completely necessary (purchase a vehicle or piece of equipment) or deduct expenses that would normally be considered personal in order to decrease their tax liability. This is very common and usually perfectly legal, however, it makes valuing a closely-held main street business more complicated than finding EBIT or EBITDA on a company’s financial statement. This requires the need to recast the profit and loss statements in order to show a potential buyer what the owner actually earns from the business.
Also, when determining SDE, it is very important to understand how many hours the owner works in the business and what his/her day-to-day duties are. Here are some scenarios you may run into when determining SDE:
Dave owns a plumbing company that he manages full-time. He made $250,000 profit last year after paying himself a $100,000 salary. SDE is $250,000 + $100,000 = $350,000.
Bob owns a plumbing company but has a full-time manager. Bob comes into the office sometimes but is mostly a hands-off owner. He made a $200,000 profit last year after paying himself a $50,000 salary and his manager a $100,000 salary. SDE is $200,000 + $50,000 + $100,000 = the same $350,000 since a new owner could choose to replace the manager and run the company full-time. Therefore, both the owner’s and manager’s salary would become part of the total available cash flow.
Owners of main street businesses are often discouraged to learn that EBIT/EBITDA multiples only make sense for larger companies with hands-off ownership that doesn’t manipulate the financials to save on taxes. However, consider another scenario:
A massage therapy business records a net profit of about $30,000 after paying herself a $45,000 salary, her other therapist receives $15,000, and about $10,000 is deducted in personal expenses such as meals, entertainment, and cell phone charges. The owner works about 15 hours a week, and her other therapist works 25 (so both of them equal one full-time working owner/therapist). SDE is approximately $100,000.
The value of the company based on a multiple of profit (EBIT) of $30,000, without making any adjustments for the owner’s salary or other perks, is $60,000 -$180,000. Conversely, the valuation based on SDE ranges from $200,000 – $300,000, making their company is worth more based on a lower SDE multiple than a higher EBIT/EBITDA multiple.
Your Texas Business Valuation Experts
Published September 17, 2019
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