We are representing a company that is for sale, and a few days ago I received the following about that company:
I decided to pass on this business. The reason is following:
- I do not agree with your adding back full owner’s salary of $120K and car expenses of $14K. Owner’s salary is entirely addable only in case of absentee ownership. Correctly it shall be normalized by replacing by market manager’s compensation. Compensation of $120K seems for me market. As well manager shall have company car. So here we have $135K deducted from SDCF.
- You forgot to deduct CapEx ( expected capital expenditures). I may expect correct CapEx for such company as $100-150K. So in total we have reduction of about $250K Such company, worth max 2x multiple of last year or $xxMM.
I understand anyone passing on buying a business for any number of reasons. But a couple of things about this email I couldn’t let go.
Adding back owner’s salary to Seller’s Discretionary Earnings (SDE) has nothing whatsoever to do with absentee ownership. It is the definition of SDE. You always “add-back” owner’s salary. I think the gentleman was getting SDE confused with Discounted Cash Flow. It is confusing, because many brokers use the term Seller’s Discretionary Cash Flow SDCF and SDE interchangeably. Really they are not, because SDE is not a true cash flow number. There is an effort by the IBBA (www.ibba.org) and IBA (www.go-iba.org) to get all brokers and M&A advisors to use the terms SDE (or just DE) instead of SDCF or SCF.
It is important to understand that what is used in many valuations of small/medium sized businesses and what is posted on the business-for-sale websites is SDE. None of the companies listed on bizben.com, bizbuysell.com, etc. should include owner’s salary or manager’s salary, unless they state otherwise. If some did and some didn’t, we would lose the ability to compare similar companies.
CapEx is also not included, although this is some argument that can made to include this expenditure. Why not included? Because SDE is a term used for small to medium sized businesses – where the market approach to valuation is typically used. Since manager’s salary and CapEx are subjective, and honestly many brokers have a hard time coming up with consistent values for these, they are left out.
There are “done deal” databases such as Bizcomps, BVMarketdata and others that business appraisers use to statistically compare companies. If some brokers included owner’s salary if a business were absentee ownership (in their opinion) and others did not, you could not compare them. Same with CapEx. If a business was a heavy consumer of equipment, then this would naturally appear as a low multiple when comparing done deal data. This does break down sometimes when there isn’t a lot of data. Also, if a company has not historically kept up with equipment purchases (i.e. run down equipment), there should be an adjustment for this.
You can include a manager’s salary, but this is called EBITDA. It is a different number and different definition than SDE. Certainly, you can not apply a rule-of-thumb SDE multiple to EBITDA as this gentleman appears to have done. It doesn’t make sense.
You can also include CapEx, but this is typically included when doing free cash flow and discounted cash flow analysis, which is called the Income approach to valuation. Certainly these are valid things to do. In fact, I wrote previously about a valuation program, BVX, that I use that takes manager’s salary and CapEx into account, then calculates a business value based on the expected ROI of the buyer.
In the end, this buyer also questioned whether the earnings level of the company was sustainable, and in his conservative view that alone was sufficient means to pass on the opportunity. Which was fine. However after some email exchanges I was still unable to convince him about manager’s salary and SDE. Oh well, I tried.