"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 - Buyers will acquire a business and the assets via an asset purchase agreement with the Seller. The SDE does not include Cash, Accounts Receivable and Accounts Payable.
Debt free business - A buyer usually does not assume any of the Seller's 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 due to added payroll costs post-purchase.
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. However, Buyers should compare internal statements that may be on a cash basis and not accrual.
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.
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)
Small Business acquisitions are very different than bigger middle market deals. Larger deals will often have audited financial statements due to bank debt and covenants that require timely reports. Buyers should take the time to fully understand the business financial statements given by the broker prior to making an offer for the business. Allow Due Diligence as your opportunity to verify the expenses and revenue for three years. Speak to a qualified CPA that understands small business tax returns and accounting.