Posted by: bizsale | March 30, 2009

Should you use a Seller Cash Flow multiplier or an EBITDA multiplier for estimating business value?

First off, let me say that despite the fact that many people (including business brokers) like to use a Market Comparable Approach to value for sake of simplicity, I am not a big fan of the approach because it is backwards looking, fails to take into consideration unique characteristics of the business, is often based on limited dubious data, ignores differences in business models within an industry, and just because one person paid a particular price for a business doesn’t necessarily mean that’s what they should have paid (they may have under-paid or over-paid).   

Let me back up a moment, and make sure we are on the same page about how a market comparable approach is calculated.  In a market comparable approach to value, financial data from relatively similar sold businesses is collected and used to derive sales price multiples.  For example, if a business broker reported to a sold business comparable database that a business sold for $5 million and had $5 million in revenue, $850,000 in Earnings Before Interest Taxes Depreciation & Amortization (EBITDA), and $1,000,000 in Seller Discretionary Earnings (SDE), it would be said to have sold for 1X revenue, 5X SDE, and 5.88X EBITDA.  Those multipliers are then averaged with other comparable businesses and then applied to the business being valued.  So, if the business being valued had $700,000 in EBITDA and the EBITDA multiplier was 5.88, the imputed value would be $4.116 million.

Sometimes, when people are looking at value they will average the different resulting measurements of value.  For example, if a the revenue multiplier resulted in a value of $7 million, the SDE multiplier resulted in a value of $4.5 million, and the EBITDA multiplier produced a value of $5 million then the value could be estimated to be $5.5 million.  Yet, more often people will understandably place far less weight on a revenue multiplier, gross profit multipliers, or other top line measurements since there could be a business with very high revenue but that is losing money.  Cash flow is really what give a business value, not top-line numbers.  It is not uncommon for business buyers and sellers to focus on one bottom-line measurement.  Yet the question is which one is most appropriate: a Net Operating Income multiplier, an EBITDA multiplier, or a Seller Discretionary Earnings multiplier?   

Seller Discretionary Earnings is EBITDA with any seller expensed compensation added back, which in theory, results in the amount of money a seller is able to take out of the business before paying interest and taxes including any salary they have paid themselves.  Many people favor an SDE multiplier because it is one of the easiest to calculate.  

Yet, despite the fact that many business brokers focus on a SDE multiplier, it is far more problematic than an EBITDA multiplier and may not produce a very realistic valuation (which can error in being too high or too low).  A business buyer should be interested in buying an income generating business, not buying a job.  However, Seller’s Discretionary Earnings include the management wages that are necessary for the owner to operate the business, whereas EBITDA assumes that the seller’s expensed compensation for managing is included as an expense. Let me give you a few examples of why this is an important distinction:

A. You could have a business (Business A) with $50,000 in Seller Discretionary Earnings (SDE) that sold for $150,000.  This would mean that the business sold for 3x SDE.  Yet, what if the owner worked 60 hours per week, and if, as the new owner, you hired an outside manager to replace the seller to operate the business and it required a salary of $70,000?  This would mean that from an investment perspective you, in essence, have a loss of $20,000.  In other words, someone who paid 3x SDE for this business bought a low paying job, and the hope of making a future profit.  

B. Let’s say that Business B has $100,000 in Seller Discretionary Earnings and sold for $300,000.  Let’s assume that for that business the seller salary was $50,000 and that this is an approximate appropriate replacement salary if you were to hire someone to run the business.  That would mean that you would have EBITDA of $50,000.  So, while the business did sell for 3x SDE, it also sold for 6x EBITDA (which is a far more relevant measure, because it factors out the compensation for labor).

C. If Business C has $175k in SDE, but where the business is set up in such a way that it requires little or no owner management time to operate (for example, 5 hours a week), and based on the limited 4 hours a week you could hire someone to take on the owner’s responsibilities for $20k, then EBITDA would be about $155k.  Contrast this with Business D that has the same level of SDE but where the owner time commitment is 70 hours a week and to hire someone to do those management tasks would require a $140k salary, leaving $35k in EBITDA.  If you paid the same multiple of SDE for both of these businesses you may be overpaying for the latter and far under paying for the former.  If the average SDE multiplier for that industry were 3.5, then both businesses would have sold for $612,500.  Yet, after paying a replacement salary for the owner of Business C, you would have EBITDA of $155k, or an annual return on investment of 25.3% and an effective EBITDA Multiplier of 3.95, but with Business D, the EBITDA would be $35k for an annual return on investment of 5.7% and an effective EBITDA Multiplier of 17.5.    

D. Multipliers are not an overly reliable way of looking at value.  Here’s why:  the multipliers that people use are derived from closed business sale comparable databases.  However, in a business sale comparable database it is not uncommon to have several very small businesses that sell for very low multiples of cash flow that weigh down the average.  The reality is that there is a pretty limited market and willingness to pay for a business that has little employee infrastructure, where an owner has worked 50-80 hours a week, and the business only produces $60k in seller cash flow.  How many people want to buy such a business?  If they do, aren’t they going to pay a very low multiple of SDE for it since really what they are buying is simply a job with future profit potential?  If you only have 20 or so comparables for a SIC code and four or five are micro businesses where a replacement salary for the owner’s position would wipe out any cash flow from the business, then that is going to heavily weigh down the average multiplier.  

One of the problems with even applying an EBITDA multiplier is that the owner of a business may significantly over-pay or under-pay him- or her-self.  Therefore, rather than using the stated EBITDA for a business being valued or the EBITDA listed for the sold comparables, I would recommend using an adjusted EBITDA multiplier that reflects an adjustment for owner compensation that is consistent with market replacement salaries.  To do this follow these steps:

1. Determine the SDE for the business being valued.  

2. Determine a full-time annual market rate of compensation for replacing the owner (the bureau of labor statistics may provide useful info).

3. Divide the annual market rate of replacement salary by 2,600 (the number of work hours for someone working 50 hours a week for a year) to arrive at an hourly rate of compensation.

4. Determine the number of hours the seller is working per week, and multiply that by the hourly rate in the last step to arrive at an estimated market replacement salary for this position.

5. Subtract the result of step 4 from the SDE of the business being valued to determine an estimate of the realistic EBITDA for the business after paying a market rate of compensation.

6. Locate the SDE for each sold business comparable,  and then subtract out the full time market rate of compensation determined in step 2.  This will give you an estimated adjusted EBITDA for each sold business comparable. 

7. Create an adjusted EBITDA multiplier for each of the comparables by dividing their sale price by the adjusted EBITDA determined for each in step 6.

8. Average the EBITDA multipliers for the comparables in step 7, to arrive at an the average EBITDA multiplier that will be applied to the business being valued.

9. Apply the average EBITDA multiplier in step 8 to the adjusted EBITDA of the business being valued which you determined in step 5.

While this methodology isn’t perfect and there are still a variety of issues that could make the market comparable approach problematic, it will be far more realistic than using a SDE multiplier or a non-adjusted EBITDA multiplier.

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