How to establish the proper multiple of SDE and justify the valuation.
There is a substantial amount of real world comparable data available from both Pratt Stats and Biz Comps. This data in addition to over twenty years experience provide us with a real world indication of the market value of a business as a multiple of seller’s discretionary earnings (SDE). If we know the business size, particular industry, location, and historical performance we can accurately predict the likely multiple of SDE.
The multiple of SDE increases as the size of SDE increases. Small businesses with SDE less than $100,000 sell for multiples in a range of 1.2 to 2.4, when SDE is greater than $100,000 we expect to see the multiples in a range of 2 to 3, and as SDE reaches and exceeds roughly $500,000 we see the range extend to 2.5 to to 3.5 or more.
Two things happen as SDE approaches and exceed $1M; first, we are likely to redefine our SDE and begin using EBITDA (for the same business EBITDA is a smaller number than SDE), and the expected multiples grow to 3.5 to 5.5. We see multiples of 5 or larger as our EBITDA reaches and exceeds $2M.
While there may be range of multiples for any given SDE, we find that most opportunities sell near the middle of the range with very few actually selling at either extreme. Given the particular attributes of any opportunity it is relatively easy to understand where the business will fall with in the range of multiples.
Attributes of the business that justify a higher multiple within the range:
- A consistent historical record of growth and profitability
- 10+ years in business
- Substantial hard asset value
- Owner retirement
- Absentee ownership
- Stable management team in place
- Long-term quality employees and customers
- A broad diverse customer base
- Apparent competitive advantages
- Proprietary or exclusive products
- Obvious opportunity for growth and/or obviously under-performing
- Very clean books and records
- Up to date assets and premises in superior condition
- Highly favorable lease terms or ownership of real property
- Desirable location
- A high demand enterprise (manufacturing, distribution, or business to business service)
- Favorable seller financing
- Easy to understand motivation for selling
Attributes of the businesses that justify a lower multiple within the range:
- An inconsistent record of historical profitability
- Less than 3 years in business
- Little if any hard asset value
- Owner critical to operations, professional practices, or consulting
- Substantial involvement of family or partners in operations
- Few employees or a high employee turnover
- Small customer base
- A few customers accounting for substantial percentage of revenue
- No apparent barrier for completion to enter the business
- No clear opportunity for growth and/or improvement in operations
- Questionable financial records
- Out dated assets in need of replacement or heavy maintenance
- Obvious deferred maintenance or capital reinvestment
- Premises in disarray and/or unsuitable for operations
- Unfavorable terms on leases
- Undesirable location
- A low demand enterprise (retail, bar, restaurant, or personal services)
- Unfavorable terms owner unwilling to finance, all cash required
- Questionable rationale for sale
Early in the process, we studied the attributes of the business and should have a good understanding whether this specific opportunity will justify a relatively high or low multiple. We can apply a reasonable multiple to our SDE and determine an expected value. We have provided detail on what the expected terms of the sale will be in the FAQ section of this site.
Generally we find a small business valued at less than $100,000 will sell with a higher percentage of value as a down payment and a smaller percentage owner carry. In fact, very small SDE numbers that provide relatively little more than a reasonable salary have no ability to provide cash for debt service and therefore often sell for all cash at a very low multiple. As the value of the opportunity grows, we find the percentage of owner carry financing grows as well; this is specifically driven by the businesses ability to fund larger debt service payments. We see that businesses sold in the $100,000 to $800,00 range generally have a down payment equal to 40% to 60% of the selling price. The terms of the sale and available financing options begin to change as we approach $1M value, and we begin to see a combination of acquisition financing available from banks and lending institutions, as well as, small percentage owner carry. As the size of the opportunity continues to grow beyond $2-3M, we find substantially more opportunity to finance the acquisition and are beyond the scope of this exercise. Data from a thousands of actual comparable sales and years of real world experience confirm these expectations.
Justify the value
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. We have provided very basic Price justification worksheet that will assist in validating any assumed value.
Understanding that the SDE of the business must provide for a reasonable management salary, payment of debt service and taxes, fund future capital expenditures, as well as provide some reasonable return on investment, we can simply calculate if at a given value the business can accomplish this.
We use our expected value given typical terms of 50% down, compute the debt service on the remaining 50% (based on 5-year amortization, 6-8% interest), deduct the anticipated debt service, a realistic salary, a reserve for capital reinvestment, taxes and a reasonable return on cash investment (include working capital) from the available SDE. If the result is substantially greater than zero our assumed value is to low, if the result is zero our value is valid, and if the result is less than zero our assumption is high.