There are many factors that impact the best time to sell your business. At the top of the list is the value of the business, adjusted EBITDA, and your net profit from the sale after taxes and fees are paid. I would like to outline a simple formula that can give you an accurate estimate of what your business is worth.
Adjusted EBITDA, Profit & Cash Flow
Let’s start with the basic principle that a business generates cash flow or profit after all expenses are paid and the value of the business is a multiple of that cash flow or profit. You hear terms like EBITDA (Earnings Before Interest, Taxes, Depreciations, and Amortization), Adjusted EBITDA, Add-Backs, Seller’s Discretionary Earnings (SDE), and Multiples. That can be confusing. Simply put, these terms refer to the profits and what multiple of the profits the buyer is willing to pay.
Where it gets interesting is pinning down how you define profits. More than 95% of the businesses in the US generate less than $5M of sales. So, let’s focus on that market.
In this market there is usually an owner or a small number of owners that are doing three things:
- Generating as much profit as possible
- Having the business pay for as many expenses as possible (including personal expenses)
- Minimizing what is paid in taxes
Let’s not be shy when it comes to minimizing the payout, the government actually encourages this. Having a strong entrepreneurial and small business economy leads to many jobs, wealth creation, many other taxes collected and stable democracy. So, given the reality of how “profits” are defined from a tax perspective and the actual cash flow the business can generate to a potential buyer, there are adjustments that need to be made.
Defining Add-Backs
These adjustments are called “Add-Backs” and fall into two categories: Reoccurring and Non-Reoccurring. See a further breakdown below:
REOCCURRING ITEMS
- Owner’s total compensation
- Compensation of other family members in business
- Medical insurance for owners or family members
- Owner and family members car expenses (monthly payment, insurance, gas, etc.)
- Travel, meals and entertainment are not 100% business-related
- Clubs (Country or golf, health, hunting/fishing, etc.)
- Phone expenses (personal and family members)
NON-REOCCURRING ITEMS
- Revenue items
- PPP loans
- Sale of asset
- Expens
- Loss on insurance claim non reimbursed
- Major repair, improvement or purchase
- Major legal, accounting or consulting expense
- Any other major expense that is reoccurring
When these are added to the net profit used for tax purposes you can arrive at what is referred to as adjusted EBITDA or sellers discretionary earnings (SDE).
EBITDA Multiple by Industry
Once the cash flow is determined, the next step is to apply a Multiple, or the number of times cash flow a prospective buyer is willing to pay for a business. In the public stock market, this is the same concept as a price/earnings ratio or P/E ratio. In private business sales, the EBITDA multiple by industry is a common tool used to estimate a business’s value.
Let’s consider HVAC contractors. For example, the following net cash flow ranges might be considered:
- Less than $1M = 2x-4x
- Between $1M – $2.5M = 3x-5x
- Less between $2.5M – $5.0M – 4x-6x
- More than $5M = 6x+
As you can see, as the business gets larger and the risk decreases, the multiple a buyer is willing to pay increases. A huge business like Apple with proven growth, sustainability, and growth potential has the market willing to pay 28x. This is multiple expansion.