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Birds, Rain and Wind – Flying to Visit Business Owners

April 2, 2011 By Leave a Comment

Another business trip to Southern California, this time to see a prospective new client and meet to discuss a serious letter-of-intent with a current client.

The weather was going to be marginal, so Graeme drove to Placerville so I wouldn’t have to do an approach into Auburn or Truckee to get him. This way I could launch into low weather and fly into clear weather as we flew south. But I didn’t get off the ground before we had a bird strike. I didn’t feel or hear it, but I clearly saw it coming and there wasn’t anything I could do. Fortunately it was small bird, but I did abort the takeoff, shut down and inspect the propeller. I also had to clean the windshield and pull feathers and stuff off the wing.

We only had short bit of flying in rain before we broke out and had a dramatic flight with lots of different layers of clouds. We had a meeting in San Diego, then a meeting at Santa Monica airport with Jerry. You may have noticed I don’t have many aerial shots of cities. For one, they don’t have the same allure to me as the mountains, and two, I’m usually too busy flying to take photos. Especially in the LA basin, where I don’t have a brain cell to spare while flying, watching for traffic and trying to stay on the ever-changing IFR routing they give me.

So this time I gave Graeme the camera, and he got some excellent shots of the LA area.

We then spent the night and headed out to Las Vegas for a quick meeting before heading home. I almost canceled because the winds were expected to be 50 mph by the afternoon. So we flew in early and expected to be out by 12 or 1 pm. It was calm when we landed, but by 11:00 am I was looking out the window and saying, “we really have to leave. “. Everyone would keep talking. I just had to interject, “I’m sorry, but I mean it. We really have to leave.”

We took off in a 35 knot wind, with a 20 knot crosswind component. I had the control wheel cranked over and rudder mashed. Everything was fine until the last few seconds before taking off, when the plane plane started going sideways. Luckily we were in the air by the time we ran out pavement or hit a taxi light. As we took off, as planned, one wing dipped significantly and we swung into a sideways crab down the runway.

As we got in the air we could see a massive dust storm approaching Las Vegas. I wish I could have gotten a photo, but I was extremely nervous trying to get above the Red Rocks area so we wouldn’t get slammed by a rotor. We did get one good drop and we both hit our heads. Later I asked Graeme if that scared him, and he said not really, it was that sideways takeoff that did. Luckily that was it, and soon we were at 12,000 feet where it was extremely slow going, but safe. For once I took the very long way home, over by Edwards Air Force base, into the Central CA valley, then up.

The first photo is mine, the others were taken by Graeme.

Southern Sierras

No idea where this is.

OK, now I'm serious. I have no idea where this is.

Filed Under: Life as a Business Broker, Trip Report

Earnout Terms: Length, Buyer Restrictions, Measurement, Etc.

April 1, 2011 By Leave a Comment

I’ve spent a few blog posts on what situations earnouts are used and how often they are used. This last post on earnouts covers how to structure an earnout.

Earnout Period
In summary, make the earnout period not too short, not too long. Too short and the seller has an incentive to act in a completely short term manner, possibly playing games with trading long term revenue with short term. Too long and it can delay and impact the integration with the buying company and/or new owner. Earnout periods of eighteen months to 3 years are the most common, but of I’ve seen them out much further.

The length of the earnout also often depends and coincides with how long the seller is still involved in the business. Naturally, the seller wants some control of the company during the earnout period to make sure the company achieves the targets.

From a study of over 100 middle market transactions by the American Bar Association in 2009:

  • Under 12 months, 4.3%
  • 12 to 23 months, 30%
  • 24 to 36 months, 36%
  • Over 36 months, 29%

Amount of Earnout
It is hard to provide much guidance on the amount, since it completely depends on the deal and how much earnings risk the buyer is trying to mitigate. I’ve done earnouts of 10% of the purchase price to 50% of the purchase price, although 20 to 30% are more common.

Earnout Measurement
A buyer will commonly wish to base an earnout on EBITDA because, after all, that is really what he cares about. A seller’s most common fear is that even if they are still around they will not have complete control over costs and therefore can not control EBITDA. Indeed, an experienced deal attorney once told me this is the issue that causes the most lawsuits after a deal is closed.

For this reason we try hard to negotiate earnouts based on revenue milestones, not EBITDA. If we fail at that, gross margins can also work. Basically, the further up the P&L statement you go, the easier it is to measure earnout.

Interestingly enough, we had a situation where measuring earnout as a percentage of EBITDA was the best solution for the seller. In this case, the seller was performing a myriad of illegal tax maneuvers to lower his taxes, and try as I might, I could not convince him to stop for even one year (for he would pay 40% in taxes, but would receive 400% in increased purchase price for each dollar earned). He admitted that all this would end when the buyer bought the company, and then the buyer would receive a windfall because EBITDA would almost magically be higher. So we negotiated an earnout on an increase in EBITDA, not in revenue and not in gross margin.

You can also measure earnout on events such as signing (or often resigning) a major contract, getting government approval (e.g. FDA approval) or launching a new product.

From two studies of over 200 middle market transactions by the American Bar Association in 2007 and 2009:

  • Earnout based on Revenue: 29%
  • Earnout based on EBITDA: 32%
  • Other: 26
  • Unknown: 13%

The transactions in the study were between $20 million and $500 million in size – fairly large. I thin a similar study of smaller deals would find that the use revenue as a measurement occurs more often than the use of earnings.

Earnout Formulas
It is also good to keep in mind that complex formulas based on revenue, gross margins or earnings are problematic when it comes to actually writing a purchase agreement and making sure that months later everyone that reads it will come away with the exact same understanding. It is pretty easy and even fun to brainstorm and draw out graphs and curves, and talk about cliffs and caps. But always keep in mind that you should keep it as simple as possible and that complex agelbra doesn’t translate well into a legal agreement.

Controls and Restrictions
A seller will often say something like, “OK, I’ll live with that earnout based on growth of 15% next year, but in return I want some reassurances – in writing”. These are some of the restrictions or buyer covenants that are often put into place during the earnout period:

  • Office will stay in same location
  • Key employee(s) will not be terminated
  • Sales compensation structure will remain the same
  • A certain amount of capital be invested in a project

However, each restriction is a negotiation in itself, which is another reason to keep everything as simple as possible. For example, it is easy to say that a key employee can not be terminated, but what if he commits extortion? You can say that sales compensation will remain the same, but the new company has a different healthcare package they use, and the fact is that some employees can get very passionate about their coverage, personal doctor, etc. You could argue this changes the compensation, so this issue needs to be addressed and covered in the purchase agreement.
In other words, the issues that need to get worked out in earnouts tend to run much deeper than many originally think about. In fact, it isn’t uncommon for earnouts to disappear late in negotiations when the parties figure out there are just too many issues to address and the complexities become apparent.

Filed Under: Earnouts Tagged With: , ,

How Common Are Earnouts?

March 24, 2011 By Leave a Comment

How often are earnouts used? Small businesses generally don’t use earnouts and for good reason. In small business transactions there are typically short transition periods (usually sellers “earn” an earnout by staying during a transition), financials are often fairly messy so measuring earnout milestones are problematic, and buyers usually want to come in and operate the business as theirs without any of the operating limitations that often occur with an earnout arrangement. They occur with small businesses, but it is not common.

However, they are fairly common for larger companies in the lower middle market and middle market. Valuation gaps between buyers and sellers are common, and that naturally leads to discussions on earnout.

It is also fairly common for earnouts to disappear later in negotiations when the challenges of actually structuring the earnout become apparent. For example, how to measure the earnout, how long to make the earnout period and what operational limitations will be placed on the buyer are all typical issues to be worked out with earnouts (my next blog post will look at these in more detail.)

For example, last year I did a deal in which there was initially an earnout. During last minute negotiations with the two buyers still left bidding, one of the buyers dropped the earnout and made that payment a non-contingent note. That swung the deal his way and the next day the seller signed that buyer’s LOI. It also simplified the purchase agreement that would soon come.

The American Bar Association puts out a deal points study in which they organize deal information from a number of middle market deals. In 2007, they analyzed 103 deals and 20% of those deals had earnouts structured into the agreements. In 2009, 104 deals were analyzed and 29% had earnouts, which makes sense given the higher volatility and risk of earnings in 2009. Those deals were squarely in the middle market between $20 million and $100 million. For lower middle market deals at $20 million and below I think there are around 50% of deals that have earnouts.

Filed Under: Earnouts Tagged With:

Earnout Series: How to Tell if an Earnout is in Your Future

March 21, 2011 By Leave a Comment

Some of my clients tell me they would never accept an earnout, but then go on to say how they believe the historical earnings don’t tell the whole story and that a buyer needs to believe the company will grow in the future.  In other words, pay more.  Unfortunately, many buyers will say, “I don’t quite believe you, prove it”.  And that’s an earnout.   Here is how to tell if an earnout makes sense when you sell your business.

When are Earnouts used?

An earnout is contingent future payments based on performance milestones.  For example, in a simple earnout arrangement an extra payment of $100,000 to the seller may be “earned” by growing the company by an additional $1 million in revenue in the 12 month period after the close of the transaction.  Earnouts are used when there is a difference of opinion on what the earnings will be in the future. The buyer says, essentially, “show me”. Earnouts are well known in the technology sector; however it really has more do with high growth scenarios than technology.

Business are Bought for Future Earnings

In looking at Earnouts, it is useful to remember that what a buyer really cares about are future earnings. Since we don’t know what future earnings will be, we generally use historical earnings for valuation. Earnout discussions naturally arise when there is a significant difference between historical earnings and future projections.

Let’s look at a few scenarios of historical vs. projected earnings.

Scenario One – Stable Earnings

This company has a stable history and a believable projection.  It isn’t hard for anyone to believe that projection. In other words, the risk is fairly low, and the seller should not expect an earnout.

The purchase price in this case should be comprised of cash and possibly a note, but unless there are other risks, the note shouldn’t be contingent on revenue or earnings – and there should not be an earnout.

Scenario Two, Supported Growth

In this scenario it is also easy to see where earnings are heading – up.  In other words the projection of future growth is clearly supported by historical trends.  However there is often some discussion about who is going to benefit from the growth. A seller may say, “You can see what will happen, so I want to base the purchase price on a high multiple, or possible use next year’s earnings”.

A buyer, on the other hand, may say that if the company grows, it will be because of his effort after he buys the company, not the sellers. After all, he certainly isn’t buying it to give all the earnings to the previous owner.

A smart seller will counter this by explaining that much of the future growth is because of the foundation he has built. The website, reputation, product, service, etc. have all come to together to build momentum that would be difficult to stop. However, what he is also saying is, “Just trust me on this”. No one likes to bet hundreds of thousands or even millions trusting someone you recently met, so earnout discussions start.

In this type of scenario, an earnout could look like the following:

A “base price” of cash and notes is calculated using historical performance, and an earnout is structured based on the company hitting certain targets.  The target may be a revenue or earnings milestone or just about anything that makes sense.  The next blog post will cover typical earnout stuctures.

Scenario 3, Unsupported Growth

We often (too often) see a scenario where the company doesn’t really have an upward trend, yet the business owner believes there could be a lot of growth opportunities. For example, the owner may say, “I never got around to putting up a website but if you built a website and sold products online, sales would double.”  In this case the buyer does have a pretty good case to say, “Well, if I spend the money and time to  build the website, then I should enjoy the rewards”.

Sometimes we can negotiate an earnout in this type of scenario, but it really depends on the situation and why exactly the seller believes growth is inevitable.

Scenario 4, Recession Proofing a Transaction

Although earnout agreements are mostly seen in growth companies, we’ve also seen it a few times in protecting the buyer from further decline during the recession.  Many companies have seen a retraction of sales and earnings from the time before the recession, and that is just fine with buyers – as long as the performance has stabilized.   We’ve seen buyers, fearful of further decline, set a purchase price on a lower “base” number, then set up an earnout target of simply staying put.  In other words, if the business does the same in revenue and earnings in the future, then additional payments are made to the seller.  If the business slides some more, then the seller gets the “base” price that was somewhat lower.

In the next few blog posts, I’ll cover how frequently earnouts happen, and how they are typically structured.

 

 

Filed Under: Earnouts, Negotiations Tagged With:

Childcare Facility: How Much is it Worth?

March 19, 2011 By Leave a Comment

I received the following question from my national blog:

NAME: XX
COMPANY: YY
TITLE: Owner

COMMENTS: I have owned my childcare facility  for 15 years and I am carefully considering buying an existing childcare for sale. I found your article about how much a business should sell for. This business for sale grosses 550k @ 70% capacity and the sellers records showed 75k profit. The are asking 300k. I feel 200-225k might be more appropriate. Any advice? Thank you, I emailed because your article has been the most imformative incising people I have talked to and research conducted!

Sincerely, XX

My response:

Dear XX,

Thank you for the note. I would agree with you.

First, you need someone to make sure about that earnings number. But if it is seller’s discretionary earnings of 75K, that means one owner made $75K per year owning and running that business. That isn’t all that much. Really they are selling a job (as opposed to something that is creating cash flow that you can save for a return on investment).  A nice job with some perks, but also some hard work. A multiple of 4 is too much. Often companies with earnings under $100K go for 2 to 2.5 earnings.

I admit I don’t know much about the market and multiples for small childcare facilities. However, there are many that are sold each year and that data is accessible. My associate Fred Hall does business valuations for banks and business owners. He recently launched an inexpensive appraisal business that will give you comparable transactions around the country, and will really narrow down that multiple for you for that level of earnings. You can reach him at: www.affordablebusinessappraisals.com. I’ve copied Fred on this message in case you want to ask him questions.

If you are serious about buying this business it would be well worth the few hundred dollars to find out what these businesses really sell for.

Regards, Ney

 

 

Filed Under: Valuations Tagged With: ,

How To Increase the Value of Your Business: Top Ten List

March 12, 2011 By Leave a Comment

Don’t wake up one morning and decide to sell your business. Wake up and decide to plan for your exit. Because if you have a year or two to plan, you can tangibly increase the value and the selling price of your business. How?

1. High Earnings = High Selling Price. Pretend nothing else matters, because, well, nothing does. At least not enough that if you had one thing to focus on to increase the value of your business, this is it.

2. Depreciate. Earnings (both discretionary earnings for small companies and EBITDA for larger ones) don’t include depreciation expense. For tax reasons business owners tend to expense rather than capitalize and depreciate, but in the year or two before a sale? Depreciate.

3. Reduce Working Capital Needs. A midsize company is sold with enough working capital (current assets minus current liabilities) to continue to operate the business. Think of it as having to sell your car with gas in the tank. Prove you can reduce this amount now (e.g. lower AR, lower inventory, increase payables, etc.) and you can take more cash home in the deal later.

4. Nix the C-Corp. If you think it will be a number of years before you close a deal, see if you can take an S-Corp election. Most buyers will want to do an asset sale (more on this later) and the double tax created by a C-Corp can be extremely painful.

5. Concentration Is a Bad Word. Businesses with high customer concentration or supplier concentration (or knowledge concentration, etc.) attract fewer buyers and this lowers the price. What’s too high? Having a customer with 25 percent or more of your business, or having a supplier with 40 percent of your business is too high. Diversify if at all possible.

6. Make Yourself Unimportant. What business would you rather buy? The one where the owner takes frequent trips and takes every Friday off, or one where the owner has to come in even when he is sick because the place will fall apart without him. A company that relies on the owner gets far less cash up front and often less overall.

7. Pay Some Taxes. Yes, everyone plays the tax avoidance game, but only to a degree. A broker/advisor can only adjust earnings only so much, so it is far better to just pay your taxes for a few years before a sale than the complications that can arise otherwise.

8. Understand What “Adjusted Earnings” Means. Well before a sale is the time to understand what adjusted seller’s discretionary earnings and/or EBITDA means. For example, some expenses will be valid adjustments, so there would be no need to work on reducing that expense, while other areas may need some real focus.

9. A Risky Business Is a Cheap Business. A legal issue dragging on? Environmental problem lurking? Buyers hate risks and risks tangibly lower the price. Identify and attack these areas before a sale.

10. Pick That Low-Hanging Fruit. We hear many business owners say things like, “Pay me X, because you can easily grow this company by doing Y, but I didn’t want to do that because of Z”. For example, “All you have to do is hire a sales manager but I didn’t because I don’t manage people well”. If you have an easy way to boost sales, do it, because you are not going to get X otherwise.

Note

This list came from an extended list of “101 Things You should Know about Selling Your Business”.

Filed Under: Valuations Tagged With: , ,

Quick Trip to See “On Hold” Clients

March 6, 2011 By Leave a Comment

Southern Sierras

The recession has put a few of my clients that are selling their businesses into a holding pattern, and I thought it would be a good idea to visit them and see how they are doing.  So I made a circuit of three clients in Las Vegas (Henderson actually), Temecula and Burbank.

It was very cold, so I preheated the plane before heading out to Henderson.  The client was nice enough to meet me at the airport so we just hung around, looked at airplanes and talked. He has some awesome opportunities before him, so I’m confident he’ll come back on the market within a year or so.   I then flew into the sunset and on into French Valley airport for the night.  I met a prospective client the next morning for breakfast, and then flew to Burbank to meet my next client for lunch.

This client has a solid company that seemed recession proof.  We even had an offer on the company in 2009, but unfortunately there were very few companies that were recession proof in 2009 and he took a hit and took himself off the market.  Things are looking up again, and we’ll see him back on the market in next year or two as his earnings rise and stabilize again.

I didn’t have to because the ceiling as at around 7 to 8,000 feet, but I flew at 10,000 feet all the way home in the clouds so I could get some safe but good solid IMC (instrument) time.   All in all a good trip.  It was nice to connect with my clients, the plane ran well, and it was a fun challenge to deal with the cold, the weather and the incessant LA air traffic.

Mono Lake

 

 

 

 

 

 

 

 

 

LA Area at Night

 

Filed Under: Life as a Business Broker

BizBuySell Survey Reveals 2011 Likely to be Stronger Year for Selling a Business

March 1, 2011 By Leave a Comment

Bizbuysell’s survey came out today, and there is some hope that the economy is indeed improving.  Bizbuysell is the largest business-for-sale website by a wide margin, having bought Bizquest last year.  And of course this good news is self-serving for Bizbuysell, but some of the stats do indeed suggest that the economy is picking up some steam.

The following is the press release for the survey:

 

BizBuySell.com’s survey results show that business owners who have been hesitant to sell may want to consider preparing their business for sale in 2011.

San Francisco, CA  — BizBuySell.com, the Internet’s largest marketplace for buying or selling a small business, today released the results from a recent survey of the nation’s business brokers on the state of the business-for-sale market.

76% of responding brokers nationwide anticipate that 2011 will be a good year to sell.  A generally positive feeling about economic recovery seems to be the driving factor for the encouraging reports about the business-for-sale market this year. More than two thirds of the brokers – 69% – who anticipate that this year will be a good year to sell a business cite “the economy in general is starting to recover” as driving their bullish outlook. Other top reasons for optimism cited by brokers include “more businesses coming on the market” and “better financing becoming available for business buyers”.

“Business owners who have been sitting on the fence ready to sell for over a year will probably get off the fence and put the business on the market,” explains one responding broker.  “While the economy is certainly not great, it is more stable [than it was] was last year.”

Another respondent expects that 2011 will be a good year for the business-for-sale market “because more people are looking to purchase a business. If financing options improve it could be a banner year for sales.”

“We’re hearing that, while the economy certainly isn’t back to what it was, business owners are starting to feel more confident about it, and they’re seeing a reprieve from the recessionary environment we’ve been in over the past few years,” says Mike Handelsman, Group General Manager of BizBuySell.com and BizQuest.com. “Based on our conversations with business sellers, brokers and buyers, we believe that stable businesses with appropriate price expectations will likely receive quality offers from prospective buyers if they come on the market during the next twelve months.”

Various Factors Continuing to Affect the Business-for-Sale Market

According to the survey, a lack of available financing is still the most common factor preventing business transactions from closing, a trend that is continuing from two previous BizBuySell.com broker surveys conducted in July and November of 2010.  Nearly half of the brokers surveyed, 48%, report financing as the biggest issue hindering business for sale transactions.  Seller unwillingness to lower their asking price is an additional issue, with 26% of the brokers surveyed reporting it as a primary factor preventing sales from closing.

However, other outlying factors, such as legislative changes, seem to be having little effect on the business-for-sale market.  62% of the brokers surveyed said that the Small Business Jobs Act has not affected business owners’ desire to sell. “I think many small business owners are still unaware of the changes and how they can benefit from them,” explains one survey respondent.  “Many of these people are too busy or burnt out to keep up with the latest information.”

The extension of the favorable long-term capital gains tax rate is having a slight effect on the business-for-sale market in 2011, but will likely be a driving factor for business owners looking to sell within the next few years.  54% of the brokers surveyed noted that the extension will have little effect on the market this year, but, as one respondent notes “sellers are unsure of what the rate will be after 2012, so many are positioning a sale within the next two years.”

“As more business owners become aware of the potential capital gains tax rate increase after 2012, we anticipate they may be more inclined to want to sell in the next year or two,” Handelsman notes.

Full Economic Recovery Still Not on the Horizon

While the brokers surveyed are feeling confident about the business-for-sale market in 2011, most respondents still don’t believe business transaction volumes will return to pre-recession levels for at least 18 months.  This is again consistent with BizBuySell.com’s two previous broker survey findings.  Of the respondents, 66% predict that business transaction volumes won’t return to pre-recessionary levels for at least another 18 months, a slight increase from the 62% of brokers who responded similarly in November, and 53% in July.

Full survey results are available to interested members of the media. Local business brokers can be provided as story sources upon request.

About BizBuySell

BizBuySell is the Internet’s largest and most heavily trafficked business for sale marketplace, with more business for sale listings, more unique users, and more search activity than any other service. BizBuySell currently has an inventory of over 45,000 businesses for sale, and more than 650,000 monthly visits. BizBuySell also has one of the largest databases of sale comparables for recently sold businesses and one of the industry’s leading franchise directories.

BizBuySell was founded in 1996 and acquired by LoopNet, Inc. in 2004. LoopNet operates the largest commercial real estate listing service online, with more than $450 billion of property listed for sale and 6.7 billion square feet of space for lease. With over 4 million members, LoopNet attracts the Internet’s largest community of commercial real estate professionals.

Filed Under: Market Conditions

Good News if You Converted from a C Corp to an S Corp in the Last 10 Years

February 25, 2011 By Leave a Comment

Selling the assets of a C-Corp (often buyers will require an asset sale over a stock sale for a variety of reasons) can result in an ugly double tax situation and the IRS doesn’t let one off the hook easily, instead creating a 10 year period conversion period.  The tax paid during that 10 year period is called the Built In Gains (BIG) tax.

However, under the Small Business Jobs Act, if the fifth year of an S Corporation’s recognition period ends before their 2011 taxable year begins, then no tax is imposed on the net recognized built-in gain for the 2011 tax year.  For example, if you are the shareholder of a “S” corp which switched from a “C” corp between more than five years ago but less than 10 years ago, you are not subject to the BIG taxes if you sell the assets of your C-Corp in 2011.

It doesn’t seem like there would all that many companies that would take advantage of this.  However, I’ve written numerous times in this blog that selling a C corporation is a challenge, and those with C Corporations should seriously consider electing S Corporation status.  It seems someone is paying attention to the burden of the BIG tax, so if you haven’t converted, consider doing it now.

Filed Under: Market Conditions

Discretionary Earnings vs. EBITDA

February 14, 2011 By Leave a Comment

SDE vs. EBITDA

Just about everyone has heard of valuing a company by using a multiple of earnings.  But did you know there are several different earnings numbers?  Here is the difference between DE or SDE, used for smaller companies, and EBITDA, generally used for larger ones.

I just got an earful from a business owner.  We did a valuation of his business, arranged through www.affordablebusinessvaluations.com and friend Fred Hall.   The owner called me up, and blasted our valuation because the value ended up at around 5 times earnings.  He said that was far too low, because he heard that 4 to 5 times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is normal, and he felt he was above normal.

He was so upset I couldn’t even explain to him that we didn’t even use EBITDA.  Since his earnings were below $500K, we used seller’s discretionary earnings (SDE).  I later calculated that the recommended selling price, as a multiple of EBITDA, was about 6.5.  So he was indeed above the “normal” of 5x.   Of course, the real problem was that the valuation was at least $1 million below what he expected.

For this short article, I’m going to have to assume you know the basics of business valuation, and how important earnings are.

BOTH DE AND EBITDA

Both DE and EBITDA attempt to standardize the earnings number by excluding items that are variable and discretionary from company to company.  For example, one company may have a heavy debt load while another may have none.  So we exclude interest expense from the both DE and EBITDA.  A buyer then calculates what his debt load will be, if any, and can adjust the earnings number to fit his situation.  Same with taxes – some companies have different tax strategies, so we use a pretax earnings number.  Depreciation and Amortization is a non-cash expense, and also are more of an accounting method rather than real-world depreciation of assets, so we exclude that as well.  Note: But don’t completely discount depreciation of assets!  Remove depreciation, but then look at expected capital expenditures (“CapEx”) so you know you have the cash flow in the future to buy needed assets.

DE (or SDE)

Discretionary Earnings (also called Seller’s Discretionary Earnings) is used for smaller companies (generally under $1 million in earnings) that are typically owned by the manager.  In this case it can be tough to separate out what the owner/operator gets vs. the earnings of the company.  So we add them together into one number.  Another way of saying that is to “addback” one owner’s salary (in addition to the interest, depreciation, etc. mentioned above).  Thus when you are looking at a business that has an SDE of, say, $200,000, you know that you have $200K to spend on living, taxes, interest and capital expenditures.  For example, if you historically have been living on a $120K salary, then you can think of the business as making $80K above that, and that $80K is available to service debt, enhance your savings account, etc.

EBITDA

EBITDA is generally used to show an investor how much a company is earning.  The investor does not actively run the company, and must pay a professional manager to do that for him.  Thus the manager’s salary is included in the earnings calculation.  It is not added back as in the SDE calculation.  Simply put, EBITDA is a way for an investor to measure the return on investment he will receive should he purchase a company.

I should mention that advanced investors go further than EBITDA and use discounted free cash flow or discounted cash flow (DCF) analysis.  EBITDA is not a true cash flow, and really what an investor wants to know is how much cash a business will generate in the future.  A DCF model includes taxes, working capital, growth, CapEx and anything that impacts cash flow, and then discounts those future cash flows to a present value.  DCF is pretty hard to do correctly, so it usually is only used for larger deals well above a few million in value.

Filed Under: Earnings, Valuations Tagged With: ,
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