Understanding the valuation of a small business is critical, particularly when the intention is to sell it. Being able to justify the business valuation becomes key, and that’s where Seller’s Discretionary Earnings (SDE) comes in. There is a considerable amount of data available from resources like Pratt Stats and Biz Comps, which can provide real-world comparable data to help ascertain the market value of a business based on a multiple of SDE. If factors such as the business size, industry, location, and historical performance are known, an accurate prediction of the multiple of SDE can be determined.
Understanding Seller’s Discretionary Earnings (SDE)
In the world of small business sales, Seller’s Discretionary Earnings (SDE) serves as a vital metric. Essentially, it’s the earnings of a business before the owner’s salary, interest expense, taxes, depreciation, and amortization. The SDE presents the total financial benefit that a business owner receives from their business and is particularly useful when valuing small, owner-operated businesses.
The Relationship between SDE and Business Valuation
Delving deeper into understanding this process, it becomes evident that the multiple of SDE increases as the size of the SDE increases. For small businesses with SDEs less than $100,000, multiples range from 1.2 to 2.4. When the SDE is greater than $100,000, the multiples typically range between 2 to 3. However, as the SDE reaches and exceeds approximately $500,000, the range extends to 2.5 to 3.5 or more.
Two critical shifts happen as the SDE approaches and exceeds the $1M mark. Firstly, there might be a necessity to redefine the SDE and begin using EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) for valuation. It’s important to note that for the same business, EBITDA would be a smaller figure than SDE. Secondly, the anticipated multiples grow to between 3.5 to 5.5. As the business EBITDA reaches and surpasses $2M, multiples of 5 or larger become increasingly common.
Where Businesses Fall in the Range of Multiples
While there is a range of multiples for any given SDE, most businesses sell near the middle of the range, with very few transactions at the extremes. Given the specific attributes of a business, it’s relatively easy to comprehend where the business will fall within the multiple range.
There are several attributes of a business that justify a higher multiple within the range. These include a consistent historical record of growth and profitability, a substantial hard asset value, absentee ownership, a broad and diverse customer base, proprietary or exclusive products, and obvious opportunities for growth.
Conversely, certain factors justify a lower multiple within the range. These include an inconsistent record of profitability, a small customer base, no clear opportunity for growth, questionable financial records, outdated assets, and an undesirable location.
Considerations in Valuing a Small Business
During the initial stages of the sales process, it’s important to study the business’s attributes to understand whether the business justifies a high or low multiple. Apply a reasonable multiple to the SDE to determine the expected value.
Generally, it’s been observed that small businesses valued at less than $100,000 sell with a larger percentage of value as a down payment and a smaller percentage owner carry. However, as the value of the business increases, the percentage of owner carry financing increases as well, driven by the business’s ability to fund larger debt service payments.
As the size of the business opportunity grows beyond $2-3M, there is substantially more opportunity to finance the acquisition. This data is confirmed by thousands of actual comparable sales and years of real-world experience.
Valuing Businesses: A Rational Approach
Often, the most effective way to look at value is to make a reasonable assumption of value and attempt to justify or validate the assumption. Understanding that the SDE of the business must provide for a reasonable management salary, payment of debt service and taxes, fund future capital expenditures, and provide some reasonable return on investment, you can calculate if at a given value the business can accomplish this.
Final Thoughts
Understanding the SDE is pivotal in assessing the worth of a business. Considering the attributes and the financial records of the business will give you a clear perspective on how much your business is worth. However, remember that each business is unique, and while these guidelines offer a good starting point, they may not be definitive in every scenario. Consider seeking professional advice for accurate business valuation.
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