What You’re Buying
Let’s look at exactly what are you buying when you buy an existing business. Normally, you will be buying the assets of the business: the furniture, fixtures, equipment, inventory, leasehold improvements, trademarks, trade names, trade secrets, tangible and intangible assets, brand names, patients, customer list, and all other assets of the business (except cash and accounts receivable). You will normally not be buying any existing liabilities of the business and you will not normally be buying the corporate shares of stock (if the seller is a corporation).
You are buying an existing, ongoing economic entity that is providing a product and/or service (or a combination of both) that customers and clients respond to by buying that business’ product and/or service in sufficient quantities to provide the business’ owner with enough income to pay all operating costs and expenses and, hopefully, also provide an income (or lifestyle) for the owner. That income is sometimes referred to as income, earnings, cash flow, owner’s benefit, seller’s discretionary earnings (SDE), or seller’s discretionary cash flow (SDCF). It is also sometimes referred to incorrectly as profit.
Discretionary Earnings and Cash Flow
For our purposes, let’s use the definition that IBBA uses for SDE or SDCF. These owner’s benefit SDE – “Adjusted earnings before taxes, interest income or expenses, non-operating and non-recurring income/expenses, depreciation, amortization, and other non-cash charges and prior to deducting an owner’s/ officer’s compensation.” To make it simpler, let’s use another of my analogies.
Let’s say that the income (sales) and expenses are like water backing up behind a dam. The top of the dam represents the break-even point. Everything below the top of the dam represents non-discretionary expenses or operating costs of the business that are necessary to produce that income (sales). They would be costs of goods sold, rent, advertising, employee cost, insurance, electric, phones, etc. Until and unless the income and sales get above the top of the dam – there is no income or discretionary cash flow for the owner. However, any and all income and cash flow “above the top of the dam” are the seller’s discretionary earnings or cash flow. That is the true owner’s benefit.
The owner can use any and all of that money any way he or she wishes. The owner can use that cash flow to buy more inventory, advertise more, pay off debts, take a trip, buy a house, car, or boat, pay him or herself more money, or whatever – it is the owner’s benefit. And if the owner is selling the business, it is the SDE that helps define value.
That is a very important number!
From a valuation point of view, it is very important because most businesses are valued and sold based on some acceptable multiple of SDE. From your standpoint, it is very important because if you buy the business, and you run the business in a similar fashion that the seller did (and you did a similar amount of sales and maintained similar expenses), you should expect to have a similar SDE, less whatever new debt service (expenses) you would have.
The basic purpose of a business is to make a living for the owner.
Now, we still need to get a lot of information to even begin to arrive at value of a specific business; however, one question can be answered pretty quickly. Do you like the business? Could you see yourself working in and working on this business for eight, ten, twelve hours per day; six or seven days per week? Would you be proud to say that you owned this business? Do you see the potential of your buying and growing this business?
Once those questions are answered, at least preliminarily, we will begin to look at the SDE, or cash flow, to see if that works for you. One thing that we know is that you are going to have to have a sufficient SDE to provide for your family’s needs – the good news is that the seller’s family has house payments, car payments, and kids that want to eat three times a day and that have to be educated just like yours.
We discuss SDE in detail in our books, videos our coaching sessions. If you need help navigating SDE and small business financials…then you might need a coach. Get in touch today!