Small businesses are complex, and this is especially true when trying to determine whether or not a business is listed for a fair price.
Taking a cursory glance at a tax return or a profit and loss statement can leave you scratching your head when comparing what you see with the listing price. How did the sellers get to that number?
The value of a business comes from it’s cash flow, meaning an operating business has value for a buyer because it generates money. This money isn’t all just cash, however, as an owner benefits from their business in a number of ways. For instance, many small business owners pay for personal expenses as part of their business to minimize their tax liability.
These owner benefits that are funneled through a business can make determining the value to a buyer a bit complicated. To help with clearing up any confusion there is a metric used to determine the value of a small business called Seller’s Discretionary Earnings, or SDE.
SDE simply means that you take anything personal that an owner gets from their business or anything that was a one-time expense (something a buyer wouldn’t have to repeat or worry about) – and you add that amount back into what the business makes so you can determine what the cash flow actually is.
What kinds of expenses get added back?
Discretionary expenses, like paying for a car or cell phone through the business. Think of these like perks that a buyer might not necessarily take, so that expense is added back in to show a buyer what the numbers look like without the added perks taken out.
Extraordinary expenses, like a very high salary paid to a family member who works in the business – a family member who would probably not be staying on once the business is sold. The amount of this salary that is above the industry norm would be added back into the business to normalize the payroll numbers. This way a new owner can see what the cash flow looks like with staff who only take a standard salary.
Non-Recurring expenses, like the cost of repairing water damage from a broken pipe. The new owner wouldn’t need to pay for something like this continually, so the one-time expense is added back in.
Non-Cash expenses, like depreciation. The tangible assets a business has, like the equipment or vehicles, will lose value over time. Although not the only factor in depreciation, you can think of this add-back as something related to what the business writes off for tax purposes.
Once all of these add-backs have been “added back”, you will be able to see the cash flow a business generates. This clearer picture will allow a prospective buyer to decide if a listing price is fair or not.
Still confused? Your business broker is there to help you untangle the parts of the small business world that are inherently complicated – like add-backs and listing prices. Talk to your broker if you think a listing price seems crazy or if you don’t agree with what was added back. They can make sense of the numbers – so you can make an informed choice about how much you would be willing to pay for a particular business.
Do you have more questions about add-backs? Would you like to know how sellers typically come up with listing prices? Ask us! Leave any questions or comments here and we would be happy to help.