ExitMap® empowers advisors to develop trust-based collaborative relationships, built around a structured coaching discovery process that helps clients envision life after their businesses.
Just over 3,000,000 businesses will change hands in the next 15 years. Those companies represent some $10,000,000,000 in potential liquidity.
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The Exit Planning Coach®John F. Dini, CExP, CEPA, CBEC
John is one of America’s most accomplished business coaches, with over 25,000 hours of face-to-face consulting exclusively for CEOs, Owners and Managing Partners. He is the Founder and Creator of the ExitMap® coaching tools, a ten hour process for structured client discovery.
The ExitMap® discovery process takes owners step-by-step through their exit options. It tests their assumptions to identify which path best meets their needs and allows you to prioritize planning activities to help them meet their goals. The process starts with three keystone reports you can see for yourself by taking an ExitMap® Test Drive.
Normalizing Cash Flow
Normalizing cash flow is done with the intention of identifying Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) or Seller’s Discretionary Earnings (SDE). These differing measures of free cash flow are not interchangeable but are used by different classes of buyers for different categories of acquisition.
Free cash flow is an important measure when calculating the value and price for any business. It is the amount that is theoretically available for servicing acquisition debt, working capital, return on investment for any cash outlay in the acquisition, and future expansion.
Understanding EBITDA and SDE
EBITDA establishes free cash flow as a measurement for most mid-market businesses. It evens out the differences in earnings caused by various tax jurisdictions. In the United States there is federal income tax at the corporate level, but many states have additional income taxes, and in some cases even smaller jurisdictions like cities may have their own income tax. These obviously impact the profitability of a company and could distort a buyer’s impression of its profitability.
EBITDA calculations do not consider owner’s earnings as part of cash flow, since the companies being examined are more likely to be acquired by investors who would replace the owner with a management executive.
SDE is the measurement used to illustrate the sum total of financial benefits available to the owner operator of a business. It assumes that the owner is running the company on a day-to-day basis. SDE encompasses not only salary, bonuses and distributions, but includes insurance and other benefits such as a company paid vehicle.
A simple way to put it is that EBITDA is the cash flow available for a return on investment. SDE is the cash flow available for a return on the owner’s labor.
Adjustments in SDE Calculations
In the SDE calculations there are two places where there is often an adjustment of expenses to market. The first is for a family member employed in the business or partners who intend to leave simultaneously with the principal owner.
In many instances family members are paid according to their needs or the needs of the business instead of at a market rate for the position. With family members who are “underpaid,” adjusting to market rate will have the effect of reducing the cash flow available in the business. This reflects the fact that the family member partner will have to be replaced by someone who is unlikely to work for a below market salary.
The opposite is of course true for family members or partners who are overpaid. Reducing their compensation to a fair market rate will add to the discretionary cash flow of the business.
A second area of adjustment is when the owner of the company also owns the real estate that the company operates in. Again, the rents paid on the real estate often reflect the owner’s objectives more than they do the practical reality of the local real estate market.
A company that is underpaying rent is having its bottom line shored up by the reduced income to the real estate entity. Overpayment of rent requires the owner to make a decision. If they expect the same rent from a new tenant, the profitability of the business as presented to a prospective buyer will be lower. Considering that most transactions involve a multiple of cash flows, you can usually point out to the owner that trying to maintain a higher rent is not in their interest as the seller of the company. Adjusting the rent to a market rate increases the cash flow of the company and presumably the basis for an evaluation multiple.
Choosing Between EBITDA and SDE
The decision of whether to use EBITDA or SDE when calculating cash flow is dependent largely on the size of the client’s business. If the company has cash flow in excess of $1 million annually or is large enough to be a likely target for professional buyers, EBITDA is the appropriate measurement for cash flow.
If the company is going to be purchased by family members, employees, or another entrepreneur and has cash flow of less than $700,000, SDE is almost always a more appropriate measurement.
Which cash flow is used is a situational decision and may change if different classes of buyers are being engaged.
ExitMap® coaching tools are designed to help advisors guide clients through their options. They require no special professional credentials, and subscriptions come with complete, personal training. In 5 meetings over 90 days you can help your clients clearly define their available resources, set their objectives, and understand how to accomplish them.
Complete our Advisor Test Drive and we will contact you to schedule a complimentary demonstration or you can simply request one here.
