How do I value my business to sell?

Some of the arguments I hear that a business owner uses to support the value of their business include the number of years it has been open, the amount of gross sales, its location, the business provides a similar range of services to its competitors but does one or two things uniquely making it worth more and the quality of the employees.

Some of these arguments have merit. For example, a business with \$5,000,000 in gross annual sales will sell for a higher price than a business with \$500,000 in gross annual sales as it will be attractive to more buyers. However, while gross sales are a good talking point, the most important number is the net income the business makes or more particularly what is called the Sellers Discretionary Earnings.

What does Sellers Discretionary Earning mean? Sellers Discretionary Earning or SDE comes from a formula. The formula includes arriving at a single final number after deducting from gross sales all the normal and true business costs to operate the business and then adding back any compensation paid to an owner, interest finance costs, depreciation, any non business expenses and making sure the costs that are used are normal market costs. It sounds a bit complicated but let’s break it down and use a simple example so it is clear what the SDE would be.

If gross annual sales are \$1,000,000 we then deduct from this figure the costs to operate the business. If the total costs are \$900,000 we are left with \$100,000 which we can call net income.

If there is a single owner of business and they work in the business we need to add back the annual compensation they are paid. Let’s say the compensation is \$50,000 so now the interim figure is \$150,000.

If the owner borrowed money to help finance the business we would add back interest expenses, say \$5,000 and any depreciation on equipment the business uses, say another \$5,000. The new

interim figure is now \$160,000.

If the owner took his family on a vacation that costs \$10,000 it’s not a true business expense so we add that back to arrive at \$170,000.

The last step is a very important step. Let’s say the owner’s wife works in the business and is paid a salary of \$50,000 and this is twice the going market rate. The approach is to add back half of \$50,000 or \$25,000 because the market rate for the job is worth the lower amount and if not adjusted, will distort the value of the business. With this calculation the new figure is \$195,000.

The same argument also goes in the other direction. If the business owns the real estate it operates from and shows no cost for rent then this will distort the value of the business because no rent is being paid and just as importantly, no rent at the market rate is being paid and therefore distorting the value of the business. If the market rent is say, \$50,000, this cost must be added so the value of the business calculates correctly. With this latest calculation the SDE is now \$145,000.

The process of doing these steps to value the business is called recasting. To do the recasting, it’s a matter of taking the tax returns of the last 3 years or the last two years and the current profit and loss statement if the tax return for the current year is yet to be completed.

In summary, hiring a professional to do this is the best strategy as some of the items can be confusing when calculating add backs or recasting as it is called. Recasting means adjusting for non-recurring income and expenses, tax oriented expenses, owner’s perquisites, insufficient or excessive expenses, non-arm’s length income and expenses, non-arm’s length assets and liabilities, such as depreciation, rent when it is non-arm’s length and owners compensation (which can go both ways, that is, it can be above or below market rate for that position.) Examples include personal insurances, retirement plans, donations, personal legal fees, personal auto expenses, personal notes receivable and payable.

The bottom line is that the value of a small business is normally based on cash flow or Sellers Discretionary Earnings, not gross sales or some other item. It will dramatically improve the chances of a business selling if the value of the business is is accurate and transparent. If the SDE is not presented clearly, it will discourage a buyer from continuing to move through the process.

Category: Personal Finance