We have heard numerous people claim various ways of valuing a business. People selling have told us they heard they can get three times the revenue for their company (this is very high), people buying said they would only pay one year’s worth of net income (this is very low). Experienced buyers and sellers take an average Seller’s Discretionary Earnings (SDE) approach with a multiple on that number. The multiple and how many years to average SDE conversations are for another time; but what is SDE?
SDE is net income, plus interest, tax, depreciation, amortization, one-time expenses, and personal expenses. All of these items are called Addbacks, because they add back money to the company’s net income. Some people call this EBITDA (Earnings Before Interest Tax Depreciation and Amortization), which from an accounting perspective is incorrect, some people call this cash flow, also incorrect.
Here is a straight-forward example. A company has revenue of $1,000,000 and $300,000 in net income, $2,000 in interest expense, does not have business tax because they are not a C-Corp, has depreciation on assets of $10,000, has amortization expense of $1,000, spent $4,000 on a COVID management training course, and bought furniture for the owner’s home and recorded it to office supplies for $6,000. Their SDE will be $323,000 ($300K + $2K + $10K + $1K + $4K + $6K), assuming this company qualifies for a 2.5 multiple, the asking price for the company would be $807,500 ($323K x 2.5). In this example we are only using one year of SDE, which is very rarely the case.
If we used the two examples from the first paragraph, three times revenue would be a price of $3,000,000, no one is going to buy that company and you will have wasted a year of your time and during that time most likely experienced declining profits as you prepared to exit the company, making the value of the company very low. Only one year net income would be $100,000, if a seller accepted this offer, they would lose out on almost a quarter of a million dollars.