3 Step Framework for How to Value Business
Step 1: Calculate Seller’s Discretionary Earnings (SDE)
Most experts agree that the starting point for valuing a small business is to normalize or recast the business’ earnings to get a number called Seller’s Discretionary Earnings
(SDE). SDE gives you a good idea of a business’ true revenue potential, that you can then use to estimate the value of the business.
Small businesses report expenses on their tax returns with an eye towards reducing their tax burden. For this reason, using revenue numbers from a business’ tax return can
underestimate how much revenue the business actually produces.
SDE gives you a better idea of the business’ true revenue potential by adding back in expenses listed on the tax return that are not necessary to run the business. It also adds
back in the owner’s salary and one-time expenses that are not expected to recur in the future. This increases the net income of the business and gives you a good idea of its
true profit potential.
Here are some examples of things that would be added back into the net income reported on the business’ tax return to calculate SDE:
- Owner’s salary and perks
- Family members on payroll
- Non-cash expenses such as depreciation and amortization
- Leisure activities, such as business golf outings
- Charitable donations
- Any personal expenses, such as the purchase of a personal vehicle, that were noted as expenses on the business tax return
- Business travel that’s not essential to running the business.
- One-time expenses that are unlikely to recur after the sale of the business, such as the settlement of a lawsuit
- In general, one-time expenses and anything that’s not essential to running the business should be added back.
Step 2: Find Out the SDE Multiplier
Generally, businesses sell for somewhere between 1 and 3 times SDE. This is called the SDE multiple or multiplier. Finding the right SDE multiple is really more of an art than a
science because it varies based on industry and geographic trends (market risk), company size, the business’ tangible and intangible assets, independence from the owner
(owner risk), and many other variables.
The biggest factor influencing the SDE multiple is usually owner risk. If the business is highly dependent on the owner, it cannot be easily transferred to new ownership, and the
business’ valuation will suffer. Market risk is also important. If you’re buying or selling a business in an industry and/or area that is expected to grow in the near future, the SDE
multiple will be higher.
Step 3: Add Other Business Assets and Subtract Business Liabilities
The final step of how to value a business is to account for business assets and liabilities that aren’t already included in the SDE multiple. Most small business sales take the legal
structure of an “asset sale.” The purchaser is buying a bunch of assets or things that make up the business. Typically, the seller retains liabilities. What is purchased will vary
from sale to sale.
Intangible assets of a business (e.g. goodwill, reputation, trademarks, etc.) are typically included in the SDE multiple. Similarly, inventory and fixtures, furnishings, and equipment
(FFE) are usually accounted for in the SDE multiple. However, “SDE multiples from different databases may include different assets in valuing a business.” For example, a
popular database called BizComps does not include inventory in its SDE multiples, so inventory must be added into the valuation separately.
Other assets like real estate (if the business owns any property), accounts/receivables, and cash on hand are generally not included in the SDE multiple. These assets should
be added into the valuation separately (as shown below) if you are purchasing them.
The final step to calculating the value of a business is to subtract any liabilities that are included in the sale, such as debt and interest payments (as shown below).
Final Business Valuation Formula
SDE * Industry Multiple
+ Real estate
+ Cash on hand
+ Any other assets not included in the SDE multiple
– Business liabilities
= Business’ Estimated Value
To properly evaluate your business, we need the following information:
1. A complete list of your equipment assets at Kijiji prices
2. Cost of Lease hold Improvements and when
3. Last 3 years of financials
4. Did you pay yourself a salary and under what category (ie, management fee/salary owners fee/salary, or salary & wages)
5. An estimation of your inventory value
6. Landlord’s transfer fee regarding lease transfer to the new owner
7. Number of employees & their wages
8. Year to date numbers regarding Gross Sales, Cost of Goods & Expenses since last year end