A commonly accepted method to price a small business is to use Seller’s Discretionary Earnings (SDE) and applying a multiplier. Essentially, SDE is an estimate of the cash flow the business produces for one working owner. The multiplier is developed from the characteristics of the business and/or sales of similar businesses.
The International Business Brokers Association (IBBA) defines Discretionary Earnings (SDE) as the earnings of a business enterprise prior to the following items:
- income taxes
- nonrecurring income and expenses
- non-operating income and expenses
- depreciation and amortization
- interest expense or income
- owner’s total compensation for one owner/operator, after adjusting the total compensation of all other owners to market value
Here are some terms as defined by the IBBA:
- Owner’s salary – The salary or wages paid to the owner, including related payroll tax burden.
- Owner’s total compensation – Total of owner’s salary and perquisites.
- Perquisites – Expenses incurred at the discretion of the owner which are unnecessary to the continued operation of the business.
Developing a Multiplier
Once the SDE has been calculated, a multiplier has to be developed. The following (just as a guideline) should be rated from 0 to 5 with 5 being the highest. For example, if the business is a highly desirable business in the current market, “desirability” would be rated a 4 or 5. If the business is in an industry that is quickly declining or nearly obsolete, “industry” would be given a 0 or 1 rating.
- Age: Number of years the seller has owned and operated the business.
- Terms: Is the seller willing to offer terms? For example, will the seller accept 40 percent as a down payment with the seller carrying back 60 percent at terms the business can afford while still providing a living for the buyer?
- Competition: Consider the local market.
- Risk: Is the business itself risky?
- Growth trend of the business: Is it up or down?
- Desirability: How popular is the business in the current market?
- Industry: Is the industry itself declining or growing?
- Type of business: Is the business type easily duplicated?
The average business sells for about 1.8 to 2.5. Obviously, if the SDE is solid and the multiple is above average, the price will be higher. Keep in mind that the price outlined includes all of the assets including fixtures and equipment, goodwill, etc. It does not include real estate or saleable inventory. The price determined above assumes that the business will be delivered to the buyer free and clear of any debt.
The price of the business is determined by applying the multiplier to SDE. Be aware, however, there are really three “prices” for a business, sometimes very different:
- Asking Price is what the seller wants.
- Selling Price is what the seller gets.
- Fair Market Value is the highest price the buyer is willing to pay and the lowest price the seller is willing to accept.
Sellers should keep in mind that the actual price of a small business is often about 80 percent of the seller’s asking price, assuming the asking price is within the range of reason. The Pulliam Company can assist in suggesting a highest, reasonable asking price.