19 Jul SDE Conversation
Below is a conversation between Tom West and a business broker asking for clarification regarding Seller’s Discretionary Earnings.
There has always been some confusion regarding SDE. It was originally termed Seller’s Discretionary Cash (SDC), and I think it was called something else before that; then it became Seller’s Discretionary Earnings (SDE). I guess someone decided Earnings sounded better than Cash. In any event, as mentioned in the following emails, it boils down to profit + addbacks (this is the discretionary part) and owner’s salary or compensation. Then the multiple is calculated and is used against the SDE calculation. The result plus or minus the inventory, depending on who you talk to, is the price.
As old-time successful veteran business brokers will say, however, the price is what the seller will take for it!
We spoke last year as I sought advice on licensing and starting down the road in brokerage … since then I have become securities and real estate licensed and have been busy with more M&A type work rather than business broker deals. I have purchased and read some of your publications and find them very useful. I do however have some questions, hopefully you don’t mind me emailing you.
As I look to listing some smaller properties, I am faced with the concept of seller discretionary earning adjustments and have some philosophical issues in my own head I am struggling to sort out!
I totally understand why an owners compensation is added to the adjustment … but when the seller is the business (works full time plus) and the sellers compensation is the only (or virtually) the only compensation in the business and it makes all the difference between a break even or a profitable enterprise then I am failing to see why the adjusted number is a fair one on which to base a multiplier.
When I see properties listed on the big websites with an asking price for a certain cashflow, is this cashflow really SDCF? And is that why a multiplier of say 2 is applied versus what would be a much larger multiple if real cashflow was used? Does the reason small businesses only sell for 2X come from the fact it is 2X SDCF versus real cashflow of what is needed to operate the business?
Any thoughts / light you can she would be most appreciated.
Those that purchase a small business are essentially buying a job. The income that the business produces can be called profit or owner’s salary or a bunch of other terms. After paying expenses, what’s left is owner’s benefit, profit, etc. If the business is a proprietorship, then whatever is left goes in the form of salary to the owner. If the business is incorporated, LLC, etc you might see an owner’s salary and a profit – but guess where the profit goes!
In large companies EBIT and EBITDA assume that the CEOs salary is paid along with all other employees, etc and what’s left is profit. The multiples are much higher than the SDE in smaller businesses. It is assumed that in SDE all other expenses are paid.
In all business multiples, they are calculated after profit and addbacks. It is the addbacks that create the problem. One who does the pricing, appraisal, etc can control the numbers by adjusting the addbacks to fit the number one is trying to achieve or the multiple. In many cases, the owner is the goodwill, in which case you are correct. However, in most small businesses, the owner is certainly important, but it is assumed that the new owner will do what the old one did.
In the larger business, it is assumed that the CEO’s replacement will continue running the company since there are other management people involved. That’s why the multiples are much higher. In main street, the multiples run from 1.5 to 3 normally.
Let’s face it everything covered in your email and my response are discussing what are commonly called rules of thumb. That’s why when using rules of thumb, the multiple of sale makes more sense since add backs, owner’s salary, etc aren’t involved.
Good hearing from you and I’m sure I just confused the issue even more.
Tom, thanks, very helpful … I bring a lot of that corporation deal baggage with me so tough for me to look at this way.