How to Evaluate a Business (Part 1)

MAINSHARES

The road to business ownership can be tough- Navigate it with an experienced team to guide you each step of the way. The Operator Network is a community designed to get you up to speed with the latest from the world of owning & operating.Some Operator Network highlights:

• SMB acquisition tactics and techniques

• Develop real-world leadership and management skills

• Network with owners and fellow Operators

• Expose yourself to the wisdom of our advisors who’ve built 8 & 9-figure businesses

• Access to accredited investors and lenders

• Get matched with SMB deals that fit your background, budget and skills

And much more.

From live workshops to action-based education and even retreats in Austin, we’re ready for you.

Check out the Operator Network Here 

Some Background

Over the last 5 years, I have bought 2 business (commercial services) and built 2 others. It’s been a busy time and I haven’t been able to write as much as I’d like. But I recently sat down for a few hours and jotted down everything I knew about evaluating businesses for sale.

Here’s Part 1 of the Series: 

If you’ve ever wondered what the hell EBITDA, SDE, FCF, UFCF, LFCF, DFCF or any of those weird finance acronyms mean, I’m going to simplify it for you.

When a business goes up for sale via a broker, the usually package the details in a CIM (Confidential Info Memorandum).

Don’t fret because it sounds fancier and more complicated than it is.

This CIM should answer some basic information for you, such as:

-What does this business do?
-Where is the business located?
-Is the business growing?
-And most importantly, How much does the business make?

But no matter what a business makes in the CIM, that is not how much the business will make for you. Do not rely on your broker, lawyer, banker, etc to tell you how to determine that number.

I will walk you through a simple guide to determine how to properly value a business.

Let’s get some terms out of the way to start:

EBITDA = Earnings Before Income, Taxes, Depreciation, & Amortization
SDE = Seller’s Discretionary Earnings
UFCF = Unlevered Free Cash Flow
LFCF = Levered Free Cash Flow
DFCF = Distributable Free Cash Flow
PnL = Profit & Loss Statement

If you are still confused, keep reading.

While EBITDA & SDE produce different numbers, I like to think of them as close cousins.

On Wall Street, bankers often use EBITDA to compare the profitability and performance of companies in various industries.

Stripping out interest, taxes, depreciation & amortization (ITDA) removes the non-operating expenses in a business.

Think about if one company has debt payments (interest) and the other doesn’t. It wouldn’t be fair to compare cash flow because one has to account for interest payments. Eliminating ITDA allows for a relatively clean comparison.

But in the SMB/ETA world, SDE is thrown around.

This is because we want to account for all the ways an owner is compensated. Some owners may take a modest salary while some may take a huge salary, pay for their cars, healthcare, and kids private schools (yes, I’ve actually seen it) via the business.

If we just compared tax returns, the business with the modest owner will look great. And the tax returns of the latter business may show very little cash.

SDE helps us understand the ability of an operation to produce cash flow.

How strong is the engine behind these numbers so to speak.

It would be simple to stop there. But you’d be greatly mistaken.

SDE lies.

As does EBITDA and every other financial metric out there. There are ways to manipulate numbers and underreport expenses in efforts to increase profits. Or overreport expenses in efforts to decrease taxable income. And in SMB land, you will see it all.

How to Cut Through the Noise

Recasting PnLs is the silver bullet when looking to evaluate companies in the small business space.

Recasting is simply the exercise of adjusting a financial statement from what was reported.

In any good CIM, there should be a PnL that shows how much revenue the company made over the last few years and a breakdown of their expenses as well. (If your broker doesn’t provide you a clean PnL in Excel, ask for one). While we don’t really care what the CIM says about the SDE is of the business, we do need the PnL as it will be the starting point of our process.

Plumbing Company Example

Let’s say, a CIM for a plumbing company comes across our desk. It’s in our geography, has good revenue, and there’s a complete picture of the business via the CIM. The CIM states the following:

Plumbing Company in Your Backyard
$3M Topline Revenue

$858k SDE (Great Margins)
Seeking 4x SDE or $3.4M Purchase Price

Recasting is all about figuring out what that SDE means to you. SDE is a funny metric. Because it tells you explicitly what it is right to your face. Seller’s Discretionary Earnings. Seller’s. But, we are buying the business. What the earnings were for the seller is kind of irrelevant to us. We need to find out the BDE (Buyer’s Discretionary Earnings) and even further, the DFCF or Distributable Free Cash Flow.

Lets walk through how we’d do that:

Below I have the PnL for the plumbing company. We’ll input the “Original” numbers into Excel and rebuild the PnL from the ground up.

Then, most critically, we will challenge every assumption about each line item in the PnL.

Some examples:

Rent:
To renew the lease at our warehouse, the new landlord is raising the rent 25%. This means our rent expense needs to be recast.

Insurance:
After an insurance audit, we found that our workers comp policy doesn’t cover our contractors. This increases our insurance expense by 25%. This also should be recast.

Management Salaries:
The seller’s wife is wearing multiple hats in the business while not taking any salary. To replace her, we need to hire an employee at a fully loaded cost of $100k/year. This should be recast.

Owner’s Salary:
The seller takes $100k salary but you deem $150k is more appropriate. This will be recast as well.

Interest Expense:
The seller only pays interest expense for a credit card he uses and does not have debt on the business. You have a 7a loan. Therefore interest expense needs to be recast.

Depreciation:
Your CPA informs you of your depreciation expense. This should be recast.

All the updates are below and recasted numbers are bolded in blue:

These adjustments made some MAJOR changes.

Net Income: $729k (original) vs $277k (recast)
EBITDA: $758k (original) vs $592k (recast)
SDE/BDE: $858k (original) vs $742k (recast)

Implications of Recasting:

I want to point out that finding these differences while recasting is very common. And that recasting can also make a business MORE profitable than it appears in a CIM as well. This is why the exercise is so important. We are always in search of, “What is this business worth to me?”

The seller wants $3.4M for this business at 4x SDE.

But this CIM is understating the expenses of this business by over $110k (mainly by having a $100k employee work for free).

At $3.4M you are paying 4.6x BDE for the business. This is one data point you will use to determine if the business is right for you. There are many others that we will get to in a future post.

DFCF

After you determine BDE, we need to figure out DFCF (row 26 above).

This is how much cash will hit your bank account at the end of year 1. A far cry from the $858k that was in the CIM. But consider you are being paid a salary of $150k.

Note that if you have investors, this is the only money that is available to them. So their return is contingent upon how high or low the DFCF number gets.

Wrap Up

This exercise is crucial. I really cannot overstate the importance of completing it for every deal you do.

You’ll often hear on Twitter someone saying that they paid 3x SDE. But in a vacuum, that means nothing. We don’t know what BDE was. We don’t know what DFCF was.

You won’t know if something is a “good deal” on SDE alone. All searchers, buyers, investors, should be adamant about finding a BDE number and working their deal from there.

You are not the seller. SDE is irrelevant to your future ownership.

If you have any questions, comments, or replies to what you read here, feel free to make it know in the comment section below or hit me on Twitter.

And if you’re interested in learning more about these opportunities, Mainshares is a great place to hang out.

Additional Notes:

• I actually invested in an SMB Deal via Mainshares earlier this year. The platform was truly A+ and I receive regular updates through the platform.

• If you don’t have your ticket to HoldCo Conf, what are you waiting for? Use my code ‘Builders’ for $1500 off!

  Subscribe