So it’s time to sell your business, and you want to critically assess your business’s recent performance to determine a fair market value for your company. The most important metric is of course SDE, seller’s discretionary earnings, the historical cash flow available to pay an owner and service debt.
While banks generally just look at the last three years of a company’s tax returns, most buyers want to examine a four or five year history. Let’s take an example. Company X shows the following SDE results (from oldest to most current) for a five year period: $400k, $450k, $500k, $350k, $550k. The average is $450 per year in SDE, but clearly how your business did five years ago is not as important as how it did last year. We address that by using a weighting (typically 1-2-3-4-5) which puts five times the importance of the results for the most recent year vs. the “ancient history” of five years ago (and remember banks don’t even care about results that old).
The weighted average in this example is $463k, slightly above the $450k arithmetic average. Buyers, sellers, bankers and brokers all buy in to this SDE calculation. But, how would things change if the fourth year’s SDE was $850k instead of $350k? Well, the arithmetic average jumps to $550k while the weighted average, aided by the strong fourth year, now climbs to $597k. Your attractive SDE reflects the fact that year four showed a record SDE for your business instead of the low water mark of $350k used in the previous example. And why shouldn’t the valuation be high? You had a great year four and year five turned out to be the second best year ever. Well, be prepared to receive some surprising pushback from potential buyers if your SDE history resembles the second scenario.
Sharp shooting buyers could (1) refer to year four as an outlier and actually discard it entirely from the average SDE calculation; and (2) use an unweighted average to avoid giving more importance to recent years which were better than early years. So you could be faced with a buyer who feels a 1-2-3-4-5 weighting does not work for him and uses a 1-1-1-0-1 (the “0” reflects ignoring year four) weighting instead. The SDE then plummets from the $597k figure which you and your broker felt reflected a fair SDE for your business to a much lower $475k figure which is in fact only $12k more than the weighted SDE of $463k in our first example. If your business is being valued on say a 4.5x multiple of SDE, you and the buyer are $549k ($597k – $475k = $122k x 4.5 = $549k) apart from the get-go.
The best way to address this event is to expect it and then communicate with all buyers that if they want to treat strong years as outliers and/or use weighting (or lack thereof) to justify a low price for your business, you are not interested in proceeding with them. This approach will quickly weed out “bottom feeders” who care more about the price of the business than its attributes. Fortunately, not every buyer will try to game an average for the SDE to justify a low purchase price, so just plan to jettison those who show that tendency and move on to more fair minded prospective buyers.