The Business Brokerage industry uses a set of standards to determine the value of a business which many times is quite different than what your accountant may tell you. When Business Brokers speak about the value of your business, they are specifically referring to what is the likely selling price range of a business. While we are experts in determining the likely selling price range, we cannot use the term ‘Valuation’ but instead the term ‘Broker Opinion of Value’. Valuation experts use a variety of acceptable methods to determine the value of a business, but the most important consideration is context. What is the reason for the valuation? Is it for a Buy-Sell agreement, a divorce, an ESOP? Business brokers limit themselves to a single event: the likely selling price of the business in today’s market.
You will hear a number of phrases when it comes to understanding how business brokers determine the most likely selling price. These include ‘Owner Benefit’, ‘Seller Discretionary Earnings’ (SDE), and ‘Adjusted Cash Flow’, each of which are synonymous in our field but Adjusted Cash Flow can define other financial details and as such is best left out of discussions when determining selling price.
For the purposes of this discussion we will use Seller Discretionary Earnings, or SDE. It is best understood upfront that it is not the net profit or loss which appears on your business tax return. The tax return is used to determine the amount of tax due from the operations of the business. Business brokers must determine what the actual value of the business is to the owner and therefore to a buyer of the business. Essentially, we are using a methodology to compare overall income (value) from the business to the income one might derive from a job. This includes the net income (or loss) from the tax return plus the owner’s wages, associated payroll taxes paid by the business on those wages, and personal benefits (usually stated as expenses) the owner runs through the business.
The de facto starting point in determining SDE is the Federal Tax Return because this document is the one attested to and signed by the business owner. It is not only the original source document used by the business broker but also the lender in all business sale transactions. The process used by business brokers to determine SDE is called ‘Recasting’. During the recasting process the broker will add-back expenses which are viewed as personal in nature (think health insurance premiums, IRA/SEP contributions, personal auto expenses, etc.) which are for the benefit of the business owner. In addition, the broker will ‘add-back’ Depreciation and Amortization (non-cash expenses), interest paid, non-recurring, and one-time expenses. It’s no surprise that business owners enjoy some great benefits of owning their business and many owners take advantage of the tax code to push the envelope when including these expenses on the tax return. However, it is important to understand that banks take a more critical view of these expenses and will throw many of them aside when reviewing the SDE calculations. Experienced business brokers know this and must let the business owner know which personal expenses are likely to be tossed out by the bank and therefore cannot be included in determining SDE and therefore the likely selling price range of the business. One might convince a prospective buyer that these are indeed acceptable add-backs but be cautioned that if a bank will be involved in funding the transaction they will be set aside.
Business owners employ a variety of bookkeeping methods and are apt to include as many personal expenses as the IRS might allow. They do walk a fine line which may or may not be accepted by the IRS during an audit but that is a discussion best left to the business owner and their accountant.
The bottom line in determining an acceptable SDE figure is that the business broker must be able to defend their SDE calculation to both buyer and the lender. If a lender will not accept the broker’s SDE calculation when their buyer is in the process of obtaining financing, then the overzealous broker is painting an unrealistic picture of what the business is most likely to sell for. Sellers should ask their brokers which add-backs will be accepted by a lender. When in doubt, bring an SBA banker into the discussion. Experienced, successful, and credentialed business brokers will not mislead sellers by painting a rosier than realistic Opinion of Value.
Once the correct SDE is calculated the broker will then research the multiples of like-size businesses within the same industry to determine the likely selling price range. This is best provided as a range to account for subtleties of the business which may impact the overall value of the business as well as general market variations etc.
Remember that it is in the best interest of seller and broker alike in the determination and agreement of the likely selling price. Sellers who don’t know How to Value a Business and come up with unrealistic prices for their firm along with the brokers who bend to the whim of the seller ultimately pay the price of an unsold business. My recommendation to sellers is to have the broker explain his or her recasting and Opinion of Value processes so that they do not approach the selling process unrealistically. Trust but verifies applies when establishing a relationship of trust and respect. If there is a gap between what you as the seller requires for an exit and the current likely selling price range determination is then take steps today to close the gap for tomorrow’s exit.