Understanding Seller’s Discretionary Earnings

If you have acquired or sold a small company, or had one appraised, you’ve probably heard the term “Seller’s Discretionary Earnings”. Or you may be thinking “Earnings are discretionary? My earnings aren’t discretionary at all!” Let’s examine this often-misunderstood term, and how it compares to EBITDA, another common earnings measure.

What is Seller’s Discretionary Earnings?

Seller’s Discretionary Earnings (“SDE”) is a calculation of the total financial benefit that a single full time owner-operator would derive from a business on an annual basis. It is also referred to as Adjusted Cash Flow, Total Owner’s Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings. Here at Exit Strategies, we prefer the term Discretionary Earnings or DE. For this article I’ll use the more common SDE.

SDE is most often used in the valuation and sale of “Main Street” businesses. While there is no precise definition of what a Main Street business is, it often refers to owner-operated companies with less than $5 million of revenue. Larger businesses primarily use EBITDA.

SDE vs EBITDA

SDE = Adjusted EBITDA + Owner Compensation (one full-time owner)
Where EBITDA = net Earnings + Interest + Taxes + Depreciation + Amortization.

So SDE is always a larger number than EBITDA. This is a bit counter-intuitive for people used to working in the middle market. They usually think of EBITDA as the large number that things are subtracted from to calculate net cash flow. And wouldn’t SDE be similar to or smaller than EBITDA? A look back at the formula clears this up.

When applying price multiples for sale or valuation purposes it’s important to accurately differentiate between SDE and EBITDA. A mismatch between the earnings measure used and the multiple applied can result in significantly overvaluing or undervaluing a business.

Normalization Adjustments

Once we calculate EBITDA (or SDE) from a company’s profit and loss statement, we need to work through normalizing adjustments. We often break normalizing adjustments into two categories: discretionary items and non-recurring items.

Discretionary Items

Discretionary expenses are those that the business paid for but are really a personal benefit to the owner. Discretionary expenses exist because owners want the “tax benefit” of expensing these items. But they also want the benefit of adding them back into earnings when it comes time to value and sell the business.

Typical discretionary expenses are owner medical or life insurance, personal travel, personal automobiles, personal meals/entertainment, and social club memberships. To qualify as discretionary, each expense must meet all three of these criteria:

  1. Benefit the owner(s)
  2. Not benefit the business or its employees
  3. Are paid for by the business and expensed on tax returns and P&Ls

Whether an expense is discretionary or not isn’t always obvious:

Definitely AdjustDon’t AdjustGray Areas
Retirement plan contributionsNetworking group membershipsTravel (business and pleasure)
Home landscapingMarketing expensesContributions

Discretionary expenses are often the subject of debate between a buyer and seller. Buyers, of course, are risk averse and dubious about all these co-mingled expenses the seller claims are “not really expenses.” Items that fall in the gray area will require extra documentation by the seller and due diligence by the buyer. Certain items that a buyer might accept won’t be accepted by a bank. Generally speaking, sellers will benefit from stopping all commingling of business and personal expenses at least three years before they sell a business.

Non-Recurring Items

The other major category is extraordinary/one time income or expenses. Adjusting for extraordinary one time income and expense makes sense because they are not expenses that are indicative of the core business operations. Common examples are restructuring costs, costs related to acts of nature, asset sales, litigation expense and emergency repair costs.  One-time expenses are also scrutinized and debated. Did that bad debt really only happen once? Or is it likely to occur again in the future?

Why is this important?

In M&A transactions buyers are concerned about risks: What aren’t you telling them? How could this investment go bad? We often say that getting to a closing is about removing roadblocks in the deal – and often the biggest among them is reducing the buyer’s level of perceived risk. With that in mind it’s important to think about the line items that go into SDE well before you go to market and do your best to reduce any areas that might fall into the “questionable” zone. The cleaner your financials are the more likely you are to sell on the best price and terms.

Bob Bates, CPA, CVA is a senior valuation analyst in Exit Strategies Group’s San Jose California office. For more information on the use of earnings and cash flow measures used in business valuation, or to discuss a current business valuation need, Email Bob at bbates@exitstrategiesgroup.com or call him at 408-769-4404.

How to Build a Sellable Construction Business

With the San Francisco Bay Area building industry booming I am regularly approached by the owners of construction companies with requests to help them to sell their companies. As interest rates are low (but creeping up) and investors are still in the market for solid businesses, some construction company owners with strong financial histories and future growth prospects are looking to cash out.

However, even in the best of times construction companies are notoriously difficult to sell. Any business that requires a professional accreditation (like a California contractor’s license) to operate will logically attract fewer buyer prospects. Buyers with the requisite licenses and financial resources often prefer to start their own companies rather than buy someone else’s. Many construction companies even large ones depend heavily on their owner’s experience and contacts to attract business. When it comes to selling, the personal goodwill of the owner is tough to transfer to a new owner.

If that weren’t enough, many construction businesses have high capital equipment costs, high labor costs and because of retention are slow to receive payment for their services. Furthermore, the industry is cyclical which increases the need to maintain cash reserves. These factors increase overall working capital requirements for construction businesses and make them difficult to finance and expensive to manage.

So, what qualities in a construction company are attractive to buyers? This list is a good start:

Experienced and Dedicated Labor

Unemployment in the Bay Area hovered at just under 3% in October. The market for construction-related jobs is even tighter. For many Bay Area construction companies growth is constrained not by demand for their services but by their ability to complete the work. Some of these companies are resorting to acquisitions of other companies simply to secure talent. Owners of companies with trained and dedicated employees are well positioned to benefit from this industry wide challenge.

Committed Management Team

Businesses with multiple owners that compose the management team and want to retire at the same time are particularly challenging to sell. Business partners or spouses that both play vital roles and want to leave a business together are difficult for buyer prospects to replace. Buyers like to know that the owner can take time away from the business without it impacting performance. Ideally, a company will have a committed non-owner management team that will embrace an incoming buyer and continue to run the business after its sold.

Low Working Capital Requirements

Not all construction companies require a large working capital investment. For example, companies that provide services directly to building owners rather than general contractors often have more control over when and how they get paid. Also, companies that have regular service contracts with clients often have shorter cash flow cycles.

Qualifier Flexibility

The buyer of a construction company that is in the same business will have the required licenses to operate. But many buyer prospects for small construction companies won’t and they will have to figure out how to run the business until they are able to qualify for the requisite licenses. A business in which the seller or one of the company employees is willing and able to serve as the license qualifier during the transition will make the business easier to sell.

Construction companies with these attributes will be more attractive to buyers.

Exit Strategies Group regularly appraises and brokers the sale of companies in the construction industry. For further information or if you own a California construction company that you’d like to sell or have appraised please contact Adam Wiskind at awiskind@exitstrategiesgroup.com or (707) 781-8744.

A Lease Can Make or Break a Business Deal

The transferability of a commercial property lease can have a direct impact on the potential sale of a brick and mortar business enterprise.

Most commercial leases contain restrictions on the tenant’s power to freely transfer or assign the interest in a lease. These restrictions are necessary for the protection of the landlord, providing assurance that any successor of the business and the lease has the financial and legal wherewithal to pay the rent.

In rare cases, the lease may expressly prohibit a tenant’s right to transfer. See California Civil Code 1995.230.

Where the lease does not include any language prohibiting or restricting a tenant’s right to transfer, the tenant retains an unrestricted right to transfer. See California Civil Code 1995.210.

Leases that contain restrictions on tenant transfer may require the landlord’s consent subject to express conditions or standards. These conditions could include:

  1. Does transferee have an acceptable business reputation?
  2. Will transferee use the space in a manner that is consistent with landlord’s expectations and local zoning/use laws?
  3. Is the transferee in good financial standing?

Should the lease contain restrictions on tenant transfer but provide no standard or condition for withholding consent, the transferability is subject to the implied standard that the landlord’s consent may not be unreasonably withheld. Where the landlord withholds consent but upon written request from tenant, provides no grounds for reasonable objection to the transfer, the transfer may be allowed. See California Civ. Code 1995.260.

A well drafted lease balances the interests of landlord and tenant and protects the interests of all parties from the onset, during the transition of ownership, and beyond. A diligent review by your attorney of a new or existing lease is money well invested.

Don Ross is a business broker in Exit Strategies Group’s North San Francisco Bay Area office. For further information or help selling a business contact Don at 707-778-0210 or donross@exitstrategiesgroup.com

Does Your M&A Advisor have a Stamp of Approval?

When choosing a business broker, M&A advisor, investment banker or transaction intermediary to sell your company it’s wise to consider their professional designations.  Having one or more designations from the right professional organization provides validation that the individual is committed to his or her craft and has sufficient experience to manage a complex sale transaction.

For California brokers that sell main street businesses and businesses at the very low end of the middle-market (say up to $10 million revenue) there are two primary designations:

  • CBB (Certified Business Broker) is offered by the California Association of Business Brokers.  It requires that Brokers complete 16 hours of course work and have completed at least 5 transactions within the last four years.  You can find an advisor with the CBB designation here.
  • CBI (Certified Business Intermediary) is offered by the International Business Brokers Association.  The IBBA mainly serves the U.S. and Canada.  To obtain the CBI requires 68 education hours and at least 3 completed transactions.  Find advisors with the CBI designation here.

For advisors that regularly sell lower middle market companies there are two main mergers and acquisition (M&A) designations:

  • The Alliance of Merger and Acquisition Advisors is an international organization that offers the Certified Merger and Acquisition Advisor (CM&AA). To obtain this designation requires attending a 5 day course.  Find CM&AA’s here.
  • Lastly there is the Merger & Acquisition Master Intermediary (M&AMI) designation offered by the M&A Source, also an international organization and the largest association of middle-market M&A advisors in the U.S. with over 300 intermediary members. The M&A Source is a sister organization to the IBBA.  To obtain the M&AMI credential, advisors need at least 3 years of M&A experience and 40 credit hours of professional education, and must have completed at least 3 M&A transactions.  Find M&AMI’s here.

Some advisors also maintain business valuation accreditations such as the Certified Valuation Analyst (CVA), Accredited Senior Appraiser (ASA) and ABV (Accredited in Business Valuation).  These designations demonstrate a high level of proficiency in this critical part of the sale process.

All of the above designations require passing a competency test and committing to a Code of Ethics. Having a competent and ethical advisor is critical to successfully selling your business.  Having at least one of these designations should be one of your criteria when selecting an advisor.

I should point out that business brokerage in California is licensed by the Department of Real Estate.  However, having a real estate license says nothing about an advisor’s ability to handle a business transaction.

Adam Wiskind is an M&A advisor at Exit Strategies Group, Inc and is a Certified Business Intermediary.  If you are interested in better understanding this subject or in selling your business, contact Adam at awiskind@exitstrategiesgroup.com.

Recent Changes to the SBA 7(a) Loan Program for Business Acquisition Financing

SBA 7(a) loans are a popular type of financing for small business acquisitions. These loans go up to $5,000,000 and can be used to buy a business, real estate or equipment.  Several changes to the SBA 7(a) program became effective in 2018 that are worth noting.

Some of those changes include:

  1. Lower down payment.  Required down payment has been reduced from 25% of the purchase price to 10% of the project cost (project cost = purchase price + operating capital borrowed + closing costs).
  2. Longer seller note stand-by period. The old SBA rule required a seller note to be on stand-by for 24 months if it was to be considered part of the purchase down payment. The new rule requires any seller note that is part of the down payment to be on stand-by for the entire term of the loan.
  3. Loan amortization length. The old SBA rule allowed the loan term to be equal to the amortization length for the largest portion of the loan proceeds category. The new rule requires 51% of the loan category be real estate if the loan is to be amortized at the real estate term of 25 years.

ESGI’s M&A brokers stay current with the market for business acquisition debt and equity funding, including changes in the popular SBA 7(a) loan program. Our business appraisers regularly provide business appraisals for acquisition funding purposes. We work closely with California and national lenders that actively fund business acquisitions, and would be pleased to help you apply for funding or connect you with a quality lender for your next business sale, acquisition, buy-out or merger.

For more information Email Louis Cionci at LCionci@exitstrategiesgroup.com or call him at 707-781-8582.

Can I Sell My Business (C Corp Stock) Tax Free?

In some cases yes!  Congress has long recognized that small businesses investment is an important driver of the U.S. economy.  Back in 1993, to incentivize investors, they developed a rule that eliminates federal income tax on some (later revised to all) of the gain on the sale of certain C Corporation stock issued after August 10, 1993.  As M&A brokers, Exit Strategies’ advisors try to point out potential tax breaks to clients and in this article I’ll discuss Qualified Small Business Stock (or “QSBS”) from a business sale perspective.

QSBS Requirements

To qualify for this tax break, your stock has to be deemed Qualified Small Business Stock per Internal Revenue Code Sec. 1202. Here’s a summary of those requirements:

  • Must be a domestic C Corporation
  • Stock was acquired at original issuance
  • Was acquired after 8/10/1993
  • Has been held for 5 years or more at the time of sale
  • Is a small business, defined as assets of less than $50 million
  • The company is NOT engaged in professional services that are dependent on the reputation or skill of one or more employees, financial services, farming, mining or resource extraction, hotels, restaurants or other similar businesses

Depending on the issue date of the stock, 50%, 75% or 100% of the gain (up to $10 million) may be excluded from federal income tax. The gain exclusion is 50% (subject to a 7% Alternative Minimum Tax (“AMT”) add-back) for stock acquired between August 11, 1993 and February 17, 2009. Stock acquired between February 18, 2009 and September 27, 2010 is eligible for 75% gain exclusion (subject to 7% AMT add-back), and stock acquired after September 27, 2010 receives a 100% exclusion, without an AMT add-back.

Andersen Tax offers a more complete list of QSBS requirements.  In case you’re wondering, the recent Tax Cuts and Jobs Act of 2017 did not alter QSBS rules, but the reduction of the federal corporate tax rate to 21% affects the magnitude of the QSBS benefit relative to a sale of assets. It is my understanding that California’s Franchise Tax Board no longer allows an exclusion on the gain of QSBS.

M&A Perspective

Even if you hold stock that meets QSBS requirements, you may not be able to benefit from the rule because acquirers of small private businesses generally prefer to buy assets, not stock. For buyers, buying assets reduces their tax bill, improves their cash flow, and reduces potential legal liabilities. To forgo these benefits (i.e. you ask them to buy stock) buyers usually expect a meaningful price discount. Read my recent blog on personal goodwill for more on the C-Corp tax dilemma.

Given the magnitude of the QSBS tax break, especially when eligible for 100% exclusion, a seller of QSBS could give a buyer a substantial discount and still come out well ahead (compared to selling the company’s assets). Even Uncle Sam benefits in the long run!

Do you have QSBS?

The prospect of selling qualified small business stock is compelling, however determining whether your stock qualifies and claiming this benefit is not simple.  Work with a CPA that is well-versed in QSBS requirements and the steps needed to comply with them.

If you intend to sell your business some day, be aware that tax minimization strategies such as QSBS can have a major impact on how much money you take home after taxes. Some strategies can take 5 years or more to implement, so start early and be sure that your tax advisor is involved and up to the task.

*  *  *

Exit Strategies Group’s M&A brokerage professionals are dedicated to staying abreast of tax minimization strategies in business sale, merger and acquisition transactions.  Al Statz is founder and President of Exit Strategies and is based in Sonoma County California.  For further information on this subject or to discuss selling your company, Al can be reached at alstatz@exitstrategiesgroup.com or 707-781-8580.

What are the current expectations for interest rates?

One of the important factors that effect business value is macroeconomic conditions which include interest rates and the cost of capital. Business owners who want to know what is going to happen to interest rates should be aware of new leadership at the Federal Reserve.

On February 5, 2018, Jerome “Jay” H. Powell took the oath of office as the new Chairman of the Board of Governors of the Federal Reserve System, succeeding Janet Yellen.

The Federal Reserve System (“the Fed”) is the central bank of the United States. It performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest.

One of the Fed’s functions is to conduct the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. The Fed sets the federal funds discount rate to influence the interest rates banks and other lending institutions charge to business and consumers.

What does the change in leadership mean for interest rates and the economy? The new chairman is stressing continuity as he takes over as Fed chairman, which suggests the central bank will keep gradually raising interest rates in 2018, unperturbed by recent market volatility and signs of firming inflation.

Interest rates have been at historical lows since the Great Recession but are expected to continue gradual rising toward more long-term historical levels. For business owners, knowing where interest rates are headed can help in planning both ongoing operational financing needs and in understanding buyers cost of capital. If you are a business owner considering selling, now is a good time as expectations are for continued growth in the U.S. economy, and interest rates are at historic lows.

For more information on the effects of interest rates and macroeconomic conditions on business valuation and M&A activity, Email Louis Cionci at LCionci@exitstrategiesgroup.com or call him at 707-781-8582.

Current Market Multiples for Main Street Business Sales

Each quarter, The International Business Brokers Association (IBBA) and M&A Source together with Pepperdine Private Capital Markets Project and the Graziadio School of Business and Management at Pepperdine University publish a quarterly national survey of business brokers and M&A advisors called the Market Pulse Survey. Price multiples and other key metrics in the Main Street Market section of the Q3 2017 survey are presented below.

Main Street businesses are defined as those with enterprise values up to $2.0 million.

 

MEDIAN MULTIPLES PAID FOR MAIN STREET BUSINESSES

 

 

 

 

SDE is Sellers Discretionary Earnings, which is defined as earnings before owner/GM compensation (one full-time working owner), depreciation and amortization, non-operating income & expenses, nonrecurring income & expenses, interest income & expenses, and taxes.

 

PORTION OF SALE PRICE RECEIVED AS CASH AT CLOSE

 

 

 

 

WHY SELLERS WENT TO MARKET

 

 

 

WHAT WAS MOTIVATING BUYERS

Help! I Need a Broker to Sell My Company

I was recently talking with a business owner who is considering selling his California company. He had found my contact information online, and while he was interested in getting started, he really didn’t know how to evaluate a business broker’s credentials for a sale engagement. Sellers are often unsure what questions to ask. For this reason, I like to spend 15 minutes to share my relevant M&A experience, my career history, our firm’s processes and resources, and our capacity to get a deal done for the prospective client. In this blog post, I’ll focus on pertinent questions that a seller should ask when interviewing a prospective business broker or M&A intermediary.

Many sellers base their selection strictly on how well they like the broker, or on “gut feel.” While it’s vital that a seller and business broker get along well together, a seller should consider this “Likeability Quotient” along with more objective criteria.

Factors to consider when selecting a business broker:

  1. How long has the broker been selling businesses?
  2. How many transactions has the broker completed?
  3. What is the broker’s closing success rate?
  4. Does the broker’s firm have exceptional valuation expertise?
  5. How extensive is the offering memorandum that the broker prepares?
  6. Does the broker have specific domain knowledge in your industry?
  7. What size deals does the broker’s firm typically work on?
  8. How many client engagements does the broker work on at any time?
  9. Does the broker work full-time on deals, or is business brokerage a side-business?
  10. How involved does the broker stay during the due diligence and closing phases of a transaction?

Hiring the right broker to sell your business is a critically important decision. Asking the above questions will help you  select a capable, honest and hard-working business broker by objectively evaluating their background, credentials, work ethic, and capacity for successful deal making. With these questions answered to your satisfaction, add bonus points if the broker has a high Likeability Quotient.

Preparing to sell? Why clean financial records are important.

Most business owners don’t like to spend any more time on financial statements than they have to. Trust me, I was one of them!  But, when it comes time to prepare a business for a potential sale, owners need to get serious because having clean financial records is one of the most important factors in concluding a successful business sale or merger.

What do I mean by clean financial statements?

First, all relevant business transactions are recorded in a well organized chart of accounts. You should be able to present an accurate P&L and Balance Sheet for each accounting period. Most buyers will want to look back three to five years. Of course you should have followed accepted accounting methods and have applied those practices consistently over several years. Not doing so makes it harder to compare your company to its industry peers. Also, the recorded transactions should clearly reflect what is going on in your business because prospective buyers use financial statements to study how a business is managed and spot opportunities to improve operations under their ownership.

Another part of what makes financials “clean” is not having an excessive amount of commingled personal expenses, assets and liabilities on the books. When preparing your business for sale, an M&A Advisor will review your financials with you and help identify expenses, such as personal auto expenses or other owner benefits, that might be adjusted back into the net profit of the business when it is presented to potential buyers.

Think of your financial records as a window into the quality of your business overall. Presenting clear, well organized financials to buyers makes a good impression of your business. Financials that are disorganized or hard to follow give buyers the impression that there are other problems in the business, which detracts from receiving maximum value, or, even worse, causes them to walk away.

While potential buyers may be attracted to your business initially based on its top line, industry or business model, they quickly move to the important task of evaluating the details. And more often than not, that process starts with analyzing the past several years of financial statements.

You will have more buyers and can make the process of selling your business much easier by having clean financial records. If you are considering selling in the next 3-5 years and are not certain that your financials qualify as “clean”, give us a call. Or, ask your CPA to give you their objective feedback, from a buyer, buyer’s CPA, investor and lender perspective.

Mark Soeth is an M&A Advisor with Exit Strategies Group’s Roseville California office. He can be reached at (916) 307-6868 or msoeth@ExitStrategiesGroup.com. Connect with Mark on LinkedIn.