Author Archive

Valuing a Business Using Seller’s Discretionary Earnings (SDE)

Written by Gene Wright. Posted in Financial Modeling

How Small Businesses Are Valued Based on Seller’s Discretionary Earnings (SDE)

Public companies and middle market businesses are valued as a multiple of EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization.  However, smaller businesses are valued as a multiple of Seller’s Discretionary Earnings (SDE), which can be defined as EBITDA + Owner’s Compensation.  Therefore, SDE is typically the net income (or net loss) on the company tax return + interest expense + depreciation expense + amortization expense + the current owner’s salary + owner perks.

Because it is the foundation of business valuation for small businesses, SDE is an important concept to understand.   SDE is typically the net income (or net loss) on the company tax return + interest expense + depreciation expense + amortization expense + the current owner’s salary + owner perks. 

Seller’s Discretionary Earnings Normalization

To arrive at SDE, the seller’s financial statements are “normalized” (alternate terminology includes: “recast” or “stabilized”).  The typical “SDE Normalization” presents the seller’s regular income statement and then shows each normalizing adjustment (with an explanation) to arrive at the normalized SDE.

Seller’s Discretionary Earnings adjustments resulting from personal and/or discretionary expenditures

In addition to the adjustments of EBITDA + Owner’s Salary, other adjustments may be necessary.  For instance, it’s no surprise that many small business owners run a lot of personal expenses through the business that have nothing to with operating the business.  If properly documented, those personal and/or discretionary expenditures may be added back to SDE.

Other types of Seller’s Discretionary Earnings adjustments

  • Many small business owners personally own the real estate the business occupies.  If the business is overpaying or underpaying facility rent, the amount needs to be adjusted up or down to reflect the rent a prospective buyer of the business would expect to pay.
  • Occasionally there are non-recurring expenses, such as an extraordinary legal bill due to a lawsuit, that may be added back to cash flow.
  • There can also be non-recurring income (i.e. sale of a fixed asset at a large gain).
  • Some businesses employ multiple family members who may receive above-market compensation.  The above-market portion of their salaries can be added back to the extent there is sufficient expense remaining to enable a prospective buyer to replace those family members at a competitive market rate (or adjust their salaries if they stay on board).
  • These are some of the common adjustments, but there may be justification for others.

Small business valuations are based on multiples of Seller’s Discretionary Earnings

When it comes to valuing a small business (under $3,000,000 in value), SDE is the common denominator to which a multiple is then applied.

The multiples are driven by a range of financial factors including: 1) financing formulas; 2) the buyer’s need to have a reasonable return on investment after paying debt service on the acquisition; and 3) the buyer’s need to receive reasonable compensation for the time and effort required to run the newly acquired business.  There are numerous other factors, including the industry, that can also affect the selection of an appropriate multiple.

But one of the primary factors is the level of SDE itself.  For financial reasons, buyers are willing to pay a higher multiple for higher SDE.  The following is representative of the range of multiples at various “cash flow” (SDE) levels:

    SDE        Multiple            Business Value
$50,000 1.0 – 1.25 $50,000 – $62,500
$75,000 1.1 – 1.8 $82,500 – $135,000
$100,000 2.0 – 2.7 $200,000 – $270,000
$200,000 2.5 – 3.0 $500,000 – $600,000
$500,000 3.0 – 4.0 $1,500,000 – $2,000,000
$1,000,000 3.25 – 4.25  $3,250,000 – $4,250,000

CAUTION:  The above multiples do not apply to all industries.  For instance, the construction industry would typically have lower multiples than displayed above.

Seller’s Discretionary Earnings is a very important concept to understand

Because it is the foundation of business valuation for small businesses, Seller’s Discretionary Earnings (SDE) is an important concept to understand.  Having an SDE below $100,000 is a major obstacle to a successful sale of a business (but not impossible).

Why Selling a Business Takes Time

Written by Gene Wright. Posted in Selling a Business

Selling a business is a complex proposition. There are dozens of considerations, tangible and intangible, that must be considered when evaluating whether a transaction is a good fit for a buyer. Due diligenceis the process by which buyers attempt to dig into all these factors before signing off on a deal.  

In a sense, due diligence begins as soon as a buyer becomes aware of a potential deal. Every subsequent interaction — from the first Google search of the company name to the initial phone call with the business broker to the first meeting with company executives — informs whether a buyer decides to move forward with a deal.

Due diligence usually focuses on a few main areas (though the process will vary depending on the industry, the size of the business, and the buyer). These include: 

  • Business/operations: How sustainable is your company’s revenue and cash flow? What is your growth trajectory? How do your customers view your product/services? 
  • Accounting: Most buyers will conduct a review of the sellers’ financial statements (usually with the help of an outside accounting firm) to arrive at a comprehensive understanding of the target’s historical revenues, cash flows, and earnings. 
  • Legal: Buyers will engage a lawyer to review a variety of legal documents — including organizational documents, customer/supplier contracts, past litigation, real estate leases, and more — to look out for any current or potential legal liabilities. 
  • IT: A few common focuses include security vulnerabilities, ownership/structure of proprietary technology and/or custom software, and software and employee device inventories.

As part of due diligence, potential buyers typically request a wide range of documents from companies. These include but are not limited to:

  • Financial statements
  • Tax records
  • Detailed information about company assets
  • Contracts with suppliers and customers
  • Insurance coverage and any recent claims
  • Information on product/service offerings and current/past customers
  • Licenses and permits
  • Intellectual property information 
  • Information on employees and benefits 
  • Information on current/projected revenue streams

For sellers, working with a broker will help ensure you are prepared with all the necessary information ahead of time, and put your best foot forward during the due diligence process. 

At its core, due diligence is about uncovering and evaluating risk. During the process, buyers try to confirm the accuracy of the information the company has provided, as well as unearth any potential risks not detailed — whether intentionally or unintentionally. In addition to reviewing the paperwork the company provides, most buyers will also do some form of on-site due diligence in order to speak with company employees and get a better sense of how the organization functions on a day-to-day basis. Traditionally, buyers would set up a physical data room to account for the mountains of paperwork required to evaluate a deal, but today, virtual data rooms are the norm, allowing sellers, buyers, and brokers to securely store and access all the documents related to the transaction online. 

Ultimately, in addition to verifying concrete information about the business, buyers use due diligence as a time to evaluate the fundamentals of the business and gain as strong a grasp as possible on the intangible factors that are likely to play a significant role in its future success  What’s the management style of the leadership team? How engaged are its employees? How loyal are its customers? Who manages the company’s relationship with vendors and customers? Is information documented transparently, or does it live in the owner’s head? What is the market’s perception of the business, and how does it line up with its competitors? 

The timeline for due diligence varies. Often LOIs will set out a timeframe between 30-90 days for the process; however, the process often stretches beyond this (much to the chagrin of sellers).  Our firm was involved in a transaction that opened in November 2018 with an anticipated closing date for December 31, 2018. The transaction was relatively small; the value proposition easily understood. The deal finally closed on June 30, 2019 due to the buyer’s difficulty in getting firm commitments from its investment partners due to a lack of basic information that was made available early on to evaluate investment risk. The deal finally closed, but not with the first group of investors. They had long since lost patience and moved on to other opportunities.

Not all businesses sell. Some don’t sell for good reason: lack of a sustainable business model, depth of the management team, or undisclosed liabilities discovered in due diligence just to name a few.

Companies that are well prepared for the process of selling their business and transparent with respect to the information they provide can help their business brokers bring a qualified buyer to the table more quickly and improve the odds for a successful close in the most efficient timeline.  

Placeholder Post – Put Content Here

How Northstar Advisory Group Provides Value to Business Buyers

Written by Gene Wright. Posted in Buying a Business

Before you start looking at possible businesses to buy, it’s essential that we help you think through key personal and market factors. These are the key factors that should drive your selection process and define the types of businesses that you will evaluate and acquire. Finding the right business for you will be the single biggest factor in your success as a new business owner. Getting it wrong can quickly turn your dream of owning your own business into a nightmare.

We’ve outlined below 4 critical elements to success in buying a business we’ve observed over the years in working with business buyers and sellers.  

  1. Personal Interests

Since you will be investing a significant amount of time in your new business, your search should focus on an industry that is in sync with your desired lifestyle. It’s not uncommon for business owners to build a business around a personal hobby or passion. As a business buyer, you may not have that luxury, but the business you acquire must be situated in an industry that you can immerse yourself in for an extended time period and be content doing the type of work that is required of a business owner in that field. One of the key drivers of success is enjoying and being interested in what you do!

  • Skills, Talents, and Experience

Passion alone won’t guarantee your success as a small business owner–you need to be honest about your skills and experience. For example, if you have never worked in the food service industry before, it’s unlikely that you will be a successful restaurant owner until you have accumulated experience in the field.

  • Capital Requirements

You will also need to consider your capital position since some industries require higher levels of investment than others. For example, manufacturing operations usually require much more capital to acquire than small consulting firms or businesses with fewer assets. It’s critical to make sure you have enough available capital to seriously pursue an acquisition in your chosen industry. Although seller financing may be possible for a portion of the purchase price, a thorough evaluation of your current capital position can help narrow your search to the business opportunities that align with your financial means.

  • Market Research

Market research, including an evaluation of short- and long-term industry forecasts, is essential in selecting potential business acquisitions. It’s important to identify an industry with the potential to increase the value of your investment. Additionally, you will need to examine the market in your geographic area to determine whether it is already saturated or if there is room for you to compete and grow your company. We can help in evaluating the condition of the regional marketplace as well as local trends that could impact your success.

There are four ways we add value to your search for the right business.

Develop Acquisition Criteria. We work with you to help you identify acquisition criteria to save you time, effort and money.

Comprehensive Due Diligence. We assist you in developing a comprehensive due diligence approach.

Create Pricing Models. Once we identify and evaluate target companies, we focus on pricing for each acquisition target. Our comprehensive approach includes tangible and intangible assets and enables judicious evaluation of target company attractiveness.

Post-Acquisition Advisory Services. If needed, we can provide post-purchase advisory services to assist in a smooth transition to the new owners.

Finding the right small business to buy is challenging. But the rewards of owning a business can far outweigh the costs–especially if you allow us to augment your search with your personal interests and professional capabilities

Placeholder Post – Put Content Here

How Buyers Acquire Small Business Financing

Written by Gene Wright. Posted in Small Business Funding

A buyer with 100% cash is rare. Some sort of financing will most always be needed to close the deal. There are various options for financing covered below with the understanding that buyer qualification is the key element. The ability to finance a buyer purchase is often the make or break point to closing.

Let us dispel one myth; the misconception that the owner HAS TO hold a note or mortgage on the business to get a deal closed. This is not true, and it totally rests with each owner’s preference. While we contend that selling a business with some amount of owner financing makes it slightly easier to sell, we always advise owners to speak with an accountant about the pros and cons to holding a loan on their business.

Three types of financing…

  1. Owner-held financing. There may be some tax benefits using this approach.
  2. Local bank loans. Bank financing is very difficult for a buyer to secure in the small environment, since banks are risk averse. Bank lending is the primary reason for the misconception that lender financing is difficult.
  3. SBA financing through third party lending sources. This is the primary lending source used to fund buyers of small businesses. These lenders are specifically in business for small business lending. Most business buyers do not know of these types of lenders have the contacts to use them successfully.

Placeholder Post – Put Content Here

Why Did Home Depot Go To Silicon Valley?

Written by Gene Wright. Posted in Gene Wright

Thanks to shows like Shark Tank, the concept of publicly pairing entrepreneurs to investors is now a mainstream concept, piquing the interest of many Americans.

At one time, pitching a new business idea to a group of investors was an alternate option to traditional funding that made raising capital possible for the average entrepreneur. Today, thanks to the democratic nature of the Internet, there are more options and fewer barriers than ever before.

JOBS Act Progress Still Stalled. What’s Going On, McHenry?!

Written by Gene Wright. Posted in Uncategorized

Earlier this year, a California-based company raised $750,000 through debt and equity crowdfunding when the owner took advantage of a provision that allowed him to campaign on Facebook, LinkedIn, Twitter and an online crowdfunding platform.

Publicizing his campaign on personal websites is a move that really bolstered his two-year old small business. But, that option isn’t available to everyone. Why not?