Revenue, Assets, and Markets are three of the more popular approaches used to value a business. This article will focus on the different types of income used in the revenue methodology. Under the revenue approach, a business is valued based on the revenue the company generates. Buyers are most concerned with the amount of revenue that would be available to them if they acquired the company. Ordinary net income, which is reported on the income statement for tax purposes, does not represent the company’s true income based on non-cash, discretionary & non-recurring items charged by the business owner. Income is deliberately kept low to achieve the goal of reducing income taxes. Therefore, to determine the actual revenue capacity of the business, the income statement needs to be reworked during the appraisal process to obtain SDE or EBITDA. Re-casting standardizes (or normalizes) business revenues through the exclusion of discretionary, non-recurring, and variable items, enabling accurate and objective comparisons to be made between two or more businesses. The business value is then calculated by applying a multiple, consistent with the industry and the weighting of the factors affecting the business, to the amount of SDE or EBITDA.
Seller’s Discretionary Income (SDE):
Seller’s Discretionary Income (aka Discretionary Income) is generally used for businesses with adjusted income under $1 million. These businesses usually have owners who operate and receive salaries through the company. With these small businesses, it is important to determine what the ‘owner profits’ as opposed to the ‘revenues’ of the business are. This is achieved through a series of so-called ‘additional’ P&L adjustments made to business income before tax. In certain circumstances, there are negative additions such as in the case of a business that owns a building where the owner pays himself below-market rent or a family employee who performs an important business function who receives below-market wages. In both cases, adjustments are made to normalize costs to fair market value.
The most common adjustments in the recasting process are as follows:
• Add back the total compensation of one owner
– Wages
– Payroll tax
– Coverage
– 401K Contribution / Retirement
– Facilities (Club Membership, etc)
• Additional non-cash fees
– Depreciation
– Amortization
• Additional interest expense
• Additional surcharge (not required in business operations)
– Owner’s Vehicle
– Travel & Entertainment
– Phone Not Important
– Donate
• Non-recurring surcharges
– Penalty/Fine
– Attorney’s fees (e.g. related to the sale of a business)
• Adjust Rent/Rent to FMV
Earnings Before Amortization Interest Tax Depreciation (EBITDA):
Larger companies, generally with adjusted revenues of more than $1 million, use EBITDA to determine the company’s earnings. In most cases, the owner/investor does not actively direct the company’s operations and must pay the general manager to perform the function. Therefore, the calculation of EBITDA will be different from SDE because it includes manager’s compensation in the calculation of income as an expense. EBITDA is a non-GAAP measure used to determine profitability and to make comparisons between businesses and sectors because it removes the effects of accounting and financing decisions. A simple way to determine EBITDA is to subtract the owner’s compensation and benefits from the SDE. Although the EBITDA figure will be lower than the SDE, the multiple used in the valuation is usually higher, often 2-2.5 times the SDE multiple. So, as expected, the market values of the same business calculated using either method should be close to each other. If not, a determination of why and which method (or what other method) should be performed.