"In the business world, the rear-view mirror is always clearer than the windshield."
Warren Buffett, Berkshire Hathaway, Chairman
The purpose of the Seller Discretionary Earnings ("SDE") statement is to give potential buyers a better understanding of a company's economic worth and to guide valuation based on cash flow.
In my role as a business broker, one important element of the job is to explain the financial side of a business to buyers. The great majority of our listings are bought because the business is already generating profitable cash flow, have clients, vendors and most importantly good employees.
Since I'm asked so often about the Seller Discretionary Earnings statements found in our Confidential Offering Memorandums this post is a quick primer on the subject.
First, there are certain assumptions a business broker will make in the SDE including;
- Asset sale - the SDE does not include Cash, Accounts Receivable and Accounts Payable.
- Debt free business - A buyer does not assume debt and there is no interest payments calculated in the SDE.
- A new owner will be a hands on participant in the business and a full-time owner of the business post-closing. A very important point as absentee owners pay less for a business because they will need a full-time manager to run the business which lowers the price they will pay.
- Current owner may have received benefits in various forms. The SDE converts the expense to cash and its called an addback. We recommend buyers review the numbers with the business broker who represents the seller.
- Financials ideally are taken from the company's filed federal tax returns
Things to consider when reviewing the SDE
- The SDE is a report made by the Seller to potential buyers.
- Addbacks are taken from expenses already listed in the financials, there should be verifiable proof of any of the expenses considered an addback.
- There may be big differences between Internal profit and loss statements and Tax Returns, compare apples to apples. Don't compare internals to tax returns or vice versa.
- Confirm expenses are up to date - If business is behind on accounts payable (bills) the expenses are understated. Very important due diligence point!!
- Depreciation is seldom listed in the internal profit and loss but shows up in the tax return filing.
- Equipment leases - Is seller paying off the lease and transferring equipment debt free?
- Schedule M-1 on tax return reconciles books to tax returns, may explain personal expenses paid by the business which were not included on the Tax Return.
- Be aware of the difference between distributions taken out of business vs. cash generated by the business.
- Owner salary is a W-2 payment to seller, profits are paid out as distributions or dividends.
- Rent - Is the business paying fair market? If not, adjust this in the SDE calculation.
- Is the seller the owner of the real estate? Review the utility bills and other facility cost expenses.
- Rent- If the real estate is being sold along with the business, use a 25 year mortgage payment and adjust if the payment is less than the market rent.
So what are common add-backs in small market mergers and acquisitions?
- Non-cash expenses - depreciation and/or amortization
- Non-recurring expenses - bad debt expense, website development, sale of any excess equipment, late fees, facility expenses such as new carpet, painting.
- Non-operating expenses - Bank mortgage interest, credit card interest, interest expenses
- Owner operator salary, bonus, dividends, K-1 - self explanatory
- Other expenses which the owner receives in operating the business; Payroll taxes of owner, pension payments such as SEP plans, auto expenses and insurance, health insurance, professional fees, cell phones, Utilities, travel & meals, Other (Must be provable)