Main Street Business Valuation

I’ve valued hundreds of Main Street small businesses. It’s complicated.

It’s an art and a science.

I wanted to post my thought process on how I can quickly get in the ballpark of sanity on a business that’s in the 500K-5M revenue range and a likely candidate for an SBA loan.

To start, you need to gather some initial information:

  • Last full 3 years of Profit and Loss Statements
  • Current Balance Sheet
  • Details on the Lease or the Real Estate if owned
  • What does the owner pay themselves and what do they do?
  • Are any other family members employed?
  • List of Discretionary Expenses (expenses that are optional, or beneficial to the current owner)
  • Major Equipment List with Market Values
  • Unusual Events Last 3 years? Any lawsuits? PPP loans? Insurance Claims? Major Equipment bought/sold?

Before you dig in, ask yourself 4 common sense questions:

1) Do I understand how this business works?

2) Does this business work without the owner?

3) Is there ONE customer or supplier that this business is completely at the mercy of?

4) What exactly is a buyer buying here?

Don’t continue until you can answer the above 4 questions:

Yes, Yes, No, and describe what’s for sale in a way a 7-year-old could understand. No point in the analysis if you don’t have a basic understanding and believe the business is sellable/transferrable to a new owner.

OK let’s dig into the data and value this mamma jamma.

The process:

Quickly glance at the most recent P&L. Verify there’s revenue thereof sufficient size. What’s 50% of revenue? Hold that number in your head for a second and jump over to the Balance Sheet.

Look at all the major assets of interest on the Balance Sheet and the Equipment List, and Ballpark what you think the owners could sell all the “stuff” for if they ceased operating and did an orderly wind-down of the business.

Is that total higher than 50% of sales?

If so, there’s a high likelihood this business might be better off being parted out and liquidated than sold as a going concern.

In a healthy business, the sum of the parts should add up to less than the value of the whole.

I used 50% of sales because that’s about the average revenue multiple of a Main Street deal.

But revenue multiples suck because revenue is vanity and people want to buy Profit (specifically Cash Flow). So let’s stop staring at our assets and get back to the P&L.

It’s time to do an SDE-based, Income Approach to Value, which is really just 3 big parts.

  • Determining SDE the last 3 Years
  • Deciding how to Weight the last 3 Years’ SDE
  • Choosing an Appropriate Multiple to Multiply SDE to Reach our Value

Wait, some of you don’t even know what SDE is. So let’s start there.

It’s kind of the “Gold Standard” for comparing Main Street businesses to one another and valuing them.

It’s SELLER’S DISCRETIONARY EARNINGS.

Here are a few ways to think about it:

  • It’s the theoretical “Earnings Power” of the Main Street business.
  • It’s the total “Owner Benefit”.
  • It’s the “Earnings Firehose” you theoretically should have available to service acquisition debt, pay yourself or a GM to run it, reinvest for growth, or take home in profit.
  • If you owned this company, debt free, and worked in it full time (paying yourself $0) paying only necessary expenses, the SDE is what you’d make in profit.

It’s the maximum earnings possible in a normal year in the company’s current condition.

Now let’s find it.

SDE is often drastically different from Net Profit.

Remember, the owner wants to show as little Net Profit as legally possible to minimize their taxes. It doesn’t mean the company is crap. Make no assumptions yet and follow along as we build up from Net Profit to SDE.

Get out a sheet of paper or an Excel sheet and write the Net Profit down for the most recent year. Then under it, start adding and subtracting a bunch of stuff until we get to SDE.

Positive Adjustments or “Addbacks

  • Owner’s Salary and Payroll Taxes
  • Owner’s Family Member’s Salary and Payroll Taxes
  • Owners Benefits & Perks (healthcare plan for owner and family, cell phone bill, life insurance, owner’s vehicle, anything that is paid out to the owner and their family that will go away with the sale)
  • Rent if Owner-Occupied Real Estate (will subtract a fair market rent later)
  • One-Time Expenses that don’t apply to a Buyer (cost of an expansion or remodel, a one-time consultant, a big one-time abnormal bad debt, a lawsuit settlement, etc)

Don’t forget the EBITDA addbacks too:

  • Interest Expense (Buyer will buy debt free)
  • Taxes (INCOME TAXES ONLY, Buyer responsible for their own tax bill and strategy)
  • Depreciation & Amortization (phantom expenses Seller isn’t writing actual checks for)

Now let’s do some Negative Adjustments (subtractbacks??):

  • Market wages to replace Seller’s family members (family members working for a company are usually overpaid or underpaid)
  • Any “other income” that’s not the core business stuff, like interest income, selling assets
    PPP if the bookkeeper booked it as income (may require further convo into what all happened during Covid, more than this thread can cover)
  • Fair Main Street Market Rent if Owner-Occupied
  • The coming Rent increase if leased and you know LL will raise
  • One-time anomalies, windfalls of revenue not applicable to a Buyer
  • Deferred Maintenance (crap that should have already been fixed the owner neglected)
  • Capex if it’s an Equipment Heavy Business w/trucks or machines that need periodic replacement (specifically Maintenance Capex, or a budget to replace major equip necessary for current sales level. Subtracts some of Depreciation addback.)

After you do all that, you should have SDE!!! ????

Now do all that again for the other two years’ P&L data. Put them all side by side so you can see the trends. Trends say a LOT.

Now you know the theoretical, normal max earnings power of the company in the last 3 years.

Most likely you’ve got 3 totally different numbers for the last 3 P&Ls. But you need ONE SDE number to run through a multiple… this is where we move on to WEIGHTING.

Tom Petty said, “The Weighting is the hardest part.” but I’ll try to make it easy for you.

Look for the trend/pattern.

If SDE has gone ⬆️⬆️⬆️ the last 3 years and you expect that to continue, I’m okay with choosing the most recent, the best year to run through multiple for value.

If it’s been up and down ⬆️⬇️⬆️ or erratic, you need to blend the weight of the last 3 years somehow. This is part of the “art vs science” thing. Sometimes it’s appropriate to average the last 3 years. Sometimes throw one out and average the other 2, etc. Use common sense.

If it’s ⬇️⬇️⬇️, you may actually need to discount SDE substantially. Banks and appraisers won’t project growth in SDE for their SBA loan valuations, but they WILL punish you if you’re shrinking.

Also, in this situation maybe ask yourself if anyone would want it and why?

OK, now you should have chosen a weighted SDE. The last step is to multiply it by some multiple.

Most Main Street deals are in these ranges:

<100K SDE = Crap shoot. Probably 2X or less or maybe unsellable.

100K-500K SDE = 2-3.5X

500K-1M = 3-4.5X

1M+ = Different Ballgame

But those are pretty wide ranges! How do you get an accurate Main Street  value?

Well to do that we need to move away from those rules of thumb ranges and get industry ranges and pull comps. And then look at the qualitative aspects of the specific company.

I like using the Business Reference Guide from BVR, or Bizminer, or IBIS World to look up industry rules of thumb from industry experts.

But I subscribe to all the major comp databases (Peercomps, Bizcomps, etc) too and always pull comps as well.

I like to run comps by NAICS code and filter by an SDE Range. For instance, if my weighted SDE is $300K, I might do comps only between 200-400K SDE, and throw out any egregious outliers to give me a median multiple and an appropriate multiple range based on the current market.

Lazy valuators at this point will just pick the median multiple. But you can do better. Let’s say your range is:

2.2-3.7X and the Median was 2.9X

I propose comparing the subject company to the industry on a qualitative basis to determine where to place it on that multiple range.

If, compared to industry, I’ve got higher than normal margins, more recurring revenue, better systems and processes, better website and technology, a better reputation, newer equipment, etc. etc. I’ll move it up the scale. If it’s worse than average, I’ll move it down.

Again there’s some art to this, but I prepare a report card versus industry benchmarks and can support the non-median multiple I choose.

And there you have it!

Weighted SDE X Multiple = Value (if greater than the tangible asset value total you estimated in the beginning)

                  BUT WAIT, there’s more. You also need to sanity-check this from a Main Street Buyer’s perspective.

Who is the stereotypical, most likely buyer? What would they need to pay themselves? What would their cost to borrow be at today’s rates with an SBA loan?

Is there enough SDE there to have an average Buyer make a living, service the debt at today’s rates, and still have about a 25% cushion? If not, you may not have a realistic valuation.

Make sure it makes sense to a hypothetical Buyer when you go Income Approach.

 

 

/END 

Clint Fiore 

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