One Cashflow Calculation That Could Make Or Break Your Business
When he opened his session at the first annual #BossUp Conference, David Barnett, a consultant who has owned five different small businesses in his career, said the key metrics that financial professionals use to compare businesses are effectively “made up.”
“They are notional,” he said. They play no role in the day-to-day operations of a business or the taxes you pay. These metrics, including EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and SDE (Seller’s Discretionary Earnings), only come into play when you’re selling the business. But at that point each one serves an important — and, crucially, distinct — purpose.
One of the businesses Barnett owned was a brokerage which sold 36 small businesses during his ownership between 2008 and 2011. He explained that the world of small business sales is a fundamentally different place than that of larger businesses, and that has contributed to several misconceptions.
Take the term “discretionary” for example. On Wall St. the term means something different than it does on Main St. In the corporate world, money is “discretionary” only once the business has accounted for all capital projects, which may in part explain why people hear a metric like “SDE” and think it refers to money that is going to end up in the owner’s pocket. But in small businesses, SDE is affected by those capital costs.
SDE is essentially the business’ EBITDA plus the salary of the operator/manager (just one, not multiple salaries, Barnett emphasized). When you sell a small business, the selling price will be determined as a multiple of EBITDA if it’s a larger business or SDE if it’s a smaller one. The larger the business, the larger the multiple because larger businesses are generally less risky. When the EBITDA exceeds $500,000, SDE should become irrelevant. SDE is useful in smaller deals because the buyer needs to quantify the value of their labour as part of the investment they’re making.
The crucial mistake comes when buyers or brokers apply standard multiples of EBITDA to SDE. In the example cited by Barnett, (see 32:50 of his video presentation), a business selling for just over 3x its SDE resulted in a negative cash flow for the purchaser once the financing, taxes, and equipment costs were taken into account.
“3x is a standard multiple for EBITDA, not SDE,” he explained. “I see people making this mistake all the time.” In the world of SDE any multiple above 2.5 is getting very expensive, Barnett said.
“When you look at EBITDA multiples it’s a whole different league. Small businesses might sell for 3x EBITDA and a machine shop with a lot of equipment might sell for 4x, and some business with some intellectual property, a patent or something, might sell for 5x. By the time you get to 8x EBITDA you’re talking about junior publicly traded companies.”
Barnett used his presentation do demonstrate, in detail, how brokers “normalize” balance sheets — how to properly account for the cost of depreciating equipment, taxes, perks, etc. Such calculations are crucial for ensuring you don’t overpay for a business. “If you buy the right business the wrong way, you’re in the same situation any new business is in, where a 5-10% decline in sales can wipe out a good chunk of your profit,” he warned.
Such declines happen all the time. In fact, he said most small businesses will face such a dip in the first 10 years following acquisition, which is why it’s so important to ensure your business is likely to generate a return once you’ve invested in it.
Watch Barnett’s full presentation on understanding cash flow levels as a small business buyer.
Opinions expressed here by contributors are their own.
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