As with most purchases, price is key. No buyer wants to pay more than the value of something and no seller wants to sell for less than what it is worth. The same is true if you are thinking of buying an e-commerce business or any other type. As a result, buyers and sellers resort to various metrics and methods of estimating market value which can then be used to evaluate whether the price being asked is low or high. In business acquisitions, there are two commonly-used metrics which go by their acronyms — EBITDA and SDE.
EBITDA is short for “Earnings Before Interest Taxes Depreciation and Amortization.” Most often, EBITDA is calculated from business tax returns. Let’s take a hypothetical business as an example. We will choose numbers for math simplicity; not business reality. Let’s call the business Wanda’s Web Emporium. Wanda’s imagined business model is to import various merchandise from Asian countries and India and to offer the merchandise for sale online. Via mortgage financing, Wanda bought a very small warehouse in Tennessee. She has a couple of dedicated hourly employees and hires extra workers when business picks up around the holidays. Services related to her internet sales platforms are provided by outside vendors. There is inventory and a small amount of equipment.
To calculate the EBITDA for Wanda’s Web Emporium (“WWE”), we locate the net earnings on the relevant tax schedule. WWE has revenue of, say, $300,000, but for EBITDA, we look at net earnings. The net earnings are $20,000. An EBITDA analysis is a process of “adding back” expense items to get a better picture of the cash flow and market value of a business. Thus, from numbers found on the tax return, we “add back” WWE’s annual
- Interest on loans of $2,000 a month for $24,000 total
- Depreciation and amortization of $12,000 combined
- Business income taxes of $4,000
These numbers add up to $40,000 and adding them to the net earnings, the EBITDA “value” of WWE is $60,000. In general, when selling her business, Wanda will use a multiplier to set the price. For a small business like WWE, typically, the multiplier will be from one to four times the EBITDA.
However, EBITDA does not always give the best “picture” of a business’s value, particularly a small business where the owner runs the day-to-day operations. Owners of small businesses take value out of their businesses in many and varied ways. Thus, for smaller businesses, often a better metric is SDE, which stands for “Seller Discretionary Earnings.” SDE is like EBITDA in that it is a system of “adding back” expenses to the net earnings. SDE “adds back” all of the categories used in EBITDA and then ALSO “adds back” the owner’s salary/distributions and other benefits (like a dedicated vehicle expensed through the business). To continue our example, let’s assume Wanda takes annually a combined $100,000 in salary, bonus and corporate distributions and that she takes another $10,000 in benefits. From this, the SDE “value” of WWE is $170,000 — $60,000 from the EBITDA calculation and another $110,000 as Wanda’s discretionary earnings. As can be seen, SDE is a much larger number than EBITDA (and that is always the case). As such, the multiplier used to set a price for a business based on SDE will be smaller than the multiplier used for an EBITDA analysis.
Now it may be asked: Which metric should be used? In truth, both metrics should be evaluated because, by using both, a potential buyer obtains the clearest picture of the cash flow and investment value of the target business. A combined analysis allows a potential buyer to deeply evaluate the business as an investment. Consider, for example, our hypothetical owner. As a potential buyer of WWE, one key question is whether Wanda is underpaid or overpaid. Could you, as a buyer, hire a new manager for WWE at, say, $50,000 per year including benefits? If “yes,” then a lot of “investment” value is being paid to Wanda. This might be a good business to acquire.
Conversely, maybe Wanda is underpaying herself. Maybe a new CEO could legitimately demand $175,000 and $25,000 in benefits. Wanda might have many skills and talents (and maybe language abilities) that allow her to navigate export-import laws and deal with overseas manufacturers and vendors. But Wanda prefers being “her own boss,” and thus does not mind being “underpaid.” Under these circumstances and given only $300,000 in revenue, WWE might NOT be a good business to acquire since the business cannot afford to hire the CEO with the necessary skill set.
Note that, aside from which analysis is “better,” a buyer cannot rely on EBITDA or SDE alone. There are other price components. Indeed, often an asking price is broken out into various categories. In our example, WWE has inventory that must be included in the price and there is the warehouse to consider. Is that being sold with the business? What is its value?
As can be seen, business acquisitions are complex and require legal experience and business acumen. Obtaining advice, counsel and legal services from proven M&A attorneys is essential. If you need help with a business acquisition or any sort of business merger or sale, contact the talented business lawyers at Revision Legal at 231-714-0100.