- What SDE is.
- What pro forma cash flow is.
- Understanding which add-backs are appropriate and which are not.
- How to negotiate a negative add-back on the owner’s salary.
- How business sellers might use SDE to increase the valuation of their business.
- How to use pro forma cash flow statements to predict potential cash shortages.
- How pro forma cash flow and SDE can be combined to create an accurate picture of a business’ true value.
When an entrepreneur sets out to buy a business, they will encounter a lot of unknown variables. Turning these variables into points of data that you can use to make well-informed decisions is one of the most powerful steps any business owner can make.
One of the first hurdles you will come across as you embark on your acquisition journey is determining the true value of a business. Sometimes the actual worth of a company is different than the price tag, and if you were aware of that fact you might be able to negotiate a lower price.
It can also be difficult to predict how much a business is going to make in the future. If a business owner was able to divine how much money would be coming in, they might make different decisions or take different actions to increase revenues or make different investments.
Imagine how much surer you would feel in an investment if you had a complete picture of how much cash a business was generating, and also how much cash it would generate in the future. Fortunately, there are some tools we can use to gather this precise information, namely SDE (seller’s discretionary earnings) and pro forma cash flow. By combining these common accounting concepts, business owners are able to make more accurate predictions about a company’s true value and how much potential earning power it has.
What Is SDE?
In reality, there are many ways to value a business, the most common of which involves applying a multiple to the business’s EBITDA (earnings before interest, taxes, depreciation, and amortization). The problem with that is that when you encounter a business making below a certain amount, some of the business’ costs may be inflated. After all, the owner is taking their salary, they may be paying a family member more to do a certain job than they should be, and they’re likely working with their accountants to take advantage of every legitimate tax deduction possible.
To solve this problem, investors and accountants alike turn to SDE.
SDE (seller’s discretionary earnings) is a common method for evaluating businesses with gross annual revenue below $1 million. In businesses of that size the owner usually works actively in day-to-day operations, taking their pay and other benefits that come from being the owner.
In many small businesses, it can be difficult to distinguish between the profits of the company and the owner’s compensation – SDE addresses this by normalizing the company’s financial statements so lenders, investors, and potential buyers can estimate the total expected cash flow and compare the company to similar businesses.
What Is Ownership Comp?
The entire compensation that is paid to the owner-operator must be shared during a sale, including salary, payroll tax burden, and any perks. The buyer may choose to take advantage of all the same components of compensation, or they may wish to spread resources around more, but they need the information in order to make a decision.
If the owner’s salary was $120,000 and they paid seven percent in taxes, their total tax burden would increase the owner comp to $128,400. If the owner were to add any “perks,” including club dues, a personal vehicle, health insurance, or travel fees, that amount should also be added to the owner comp.
Ownership Comp is combined with a business’ EBITDA to give you the SDE.
What Is SDE and How Do You Calculate It?
The SDE is the true monetary value of a company. To start the calculation, you must begin with the company’s net profit.
Then you need to identify items that should be added to, or deducted from, that net profit. These adjustments are called “add-backs.” Here is a basic formula for calculating SDE:
SDE Formula
Profit on Income Taxes
+ Non-recurring Expenses
– Non-recurring Income
+ Non-operating Expenses
– Non-operating Income
+ Depreciation
+ Amortization
+ Interest Expense
+ Owner’s Total Compensation
––––––––––––––––––––––––––––
= SDEWhy Do Buyers Need To Know SDE?
There are a number of reasons that a potential owner may be interested in the discretionary earnings of the seller’sa business. As shown above, it helps determine the true value of a business which is an effective tool while negotiating the price.
The buyer can also use SDE to determine how much cash a business actually produces so that the owner can plan for certain capital expenditures, investing in systematization, the owner’s salary, and more.
By learning a company’s SDE, the buyer gleens a fuller picture of its value, an understanding of its earnings, and greater insight toward how they might enhance the company’s value in the future.
Understanding Add-backs
Add-backs are a portion, or the entirety, of expenses that are added back to the net income of a business so that one can discern the true economic earnings that the company creates.
Add-backs usually fall into a few categories:
- Standard
- Discretionary
- Non-recurring
- Non-operating
- Accounting adjustments
Types Of Add-backs
Some of the most commonly accepted add-backs include:
- Owner’s salary
- Owner’s payroll taxes
- Interest
- Depreciation
- Amortization
Discretionary add-backs are those expenses that don’t contribute to the regular operation of the company and are unlikely to continue when the current owner leaves. These can include:
- Personal travel
- Club dues
- Health insurance of the owner
- Donations to charity
- Personal fuel and/or vehicle for the owner
Non-recurring add-backs are those expenses that happened once and aren’t likely to happen again, including:
- Legal fees
- Consulting fees
- Technology upgrades
- Facility upgrades
- Equipment repairs or replacements
- Any transaction-related costs
Other accounting adjustments may be undertaken (and necessary) in order to get to a company’s true earnings, including:
- PPP loans
- Non-operating income
- A deal on rent
- Inventory adjustments
A Mini Case Study In Grey Areas
Acquira once looked at a home services company that donated a substantial amount of money to the church. The owners of the company argued that the donations would not be a cost incurred by the new owners and so should be added back. But as it turned out, the church was one of the company’s biggest clients so we had to ask whether the company would lose that business if the donations stopped? In that case, the charitable donation was actually a marketing expense.Negotiating Negative Add-backs
Many types of add-backs are unavoidable in a business transaction, but there are certain things that an Acquisition Entrepreneur should always be on the lookout for. For example, any add-back that drops the cash flow below a certain point (ie: $500,000) is a definite red flag.
Certain add-backs may signal non-company expenses that the previous owner was paying through the business. Anything like this should raise some eyebrows and definitely requires further investigation.
The owner’s salary is one frequent point of contention. It may not be an inappropriate add-back per se, but you will come across sellers who will try to add back the entire amount of their salary, which says that this is not an expense that the buyer will incur.
Let’s imagine a scenario where a seller-owner is paying themselves $5,000 per month. The buyer should determine what each of their responsibilities is and what the going market rate would be to hire someone else to handle those responsibilities. If the overall cost to replace the seller-owner would be higher than the owner’s salary, then the true monthly value of their salary is not an add-back, It’s a replacement cost.
The buyer can use pay analytics software to defend the fair market value of the seller’s salary.
Always be on the lookout for owner’s salaries and any other suspicious add-backs. They may be on the level, but they could also be hiding something and it falls on the buyer to do their due diligence at this phase of the acquisition in order to protect themself.
When You Should Never Use The Words “SDE” or “Add-Back”
There are certain instances when you, as the buyer, should never utter the words “seller’s discretionary earnings” or “add-back.” Namely, when you’re dealing with off-market deal sourcing.
Off-market sourcing is when you find potential businesses for sale that aren’t listed through traditional means like business brokers. If you find yourself dealing with an off-market seller, it’s best to avoid mentioning anything that would prompt the seller to start researching anything they might be able to use to inflate the price of their company.
In fact, one of the benefits of using off-market sourcing is that you can avoid dealing with brokers at all. Brokers will often encourage add-backs to help inflate the price for their clients.
What Is Pro Forma Cash Flow?
Pro forma cash flow is an estimate of the cash going into a business (cash inflows) and the money going out of a business (cash outflows) expected in a future period. Pro forma cash flow can also be known as “projected future cash flow” or simply “cash flow.”
The information is usually created as part of the annual budgeting and forecasting processes, or it can be created to show to a prospective lender or investor. This is an essential tool for small business owners as it helps them estimate when there might be cash shortages in the near-term so that the leadership team can make adequate preparations, for example obtaining additional debt or equity funding to offset a projected shortfall.
On the other hand, if the pro forma report shows that a business can expect excess cash, the information can be used to plan the best investment strategies.
Using Pro Forma Cash Flow To Make Predictions
In order to construct a pro forma cash flow, several methods are used, each looking at a different period of time. The methods include:
Short Term – This is the most accurate pro forma report, as it derives cash flows for the next few weeks. The data is obtained through expected cash receipts from outstanding invoices and cash payments from existing accounts payable.
Medium Term – This data is derived from revenues that have not yet been billed. These are estimated from the order backlog and translated into cash receipts for the subsequent few months. The expenses that are required to support the noted revenue are translated into cash payments for that period of time.
Long Term – Revenues and expenses on the budget are translated into cash receipts and payments (respectively). This is the least accurate type of report as it deals with a much longer period of time.
As noted, a pro forma report is usually accurate for the first initial weeks of the projection but drops off quickly in accuracy as the time period stretches on. To improve the reliability of the document, it must be updated regularly with the most recent information.
Pro forma cash flow reports have a number of uses, but even if the information proves to be relatively inaccurate in the long term, at the very least it ensures the leadership team is thinking about expected future cash flows.
Conclusion: Combining A Pro Forma Report With SDE
When looking at a business to see if it is a good potential acquisition, there are many factors at play. Human error or one particular bad actor can have a serious impact on how much one values a business.
SDE allows a buyer or investor to see the true value of a company before the point of purchase. It overturns certain expenses that may inflate the price tag of a business and can help negotiate a more accurate price. A pro forma statement will allow that same buyer to see how much potential the company has in the future and plan accordingly.
The combination of these two tools creates a more holistic image of a company’s value. It allows one to see the past, present, and future of a business, and helps to make a truly informed decision.
If you have any stories about finding deals that were inflated using SDE, please share them in the comments below. Sharing these experiences is a great resource for other investors.
If you’d like to learn more about how to analyze businesses yourself, we recommend you start with the Acceleration Gauntlet. If you’d like to learn more about the Gauntlet, our other training materials, or our Search Partnership Program, schedule a call with us today.
Key Takeaways
- SDE allows you to get a more complete valuation of a small business.
- Add-backs should be heavily scrutinized and can be negotiated.
- Pro forma reports are useful when it comes to creating the annual budget and forecasts.
- Pro forma reports get less accurate the further into the future they look.
- Both SDE and Pro Forma reports are useful tools for predicting how much cash a company will generate in the future.
Acquira is a business acquisition in a box service. We help entrepreneurs buy businesses and we invest in them and their chosen businesses. We are here to help ensure that each business we work with is posed to make the biggest positive impact possible for its owners, employees, and community.
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