Julie’s Big Eyes Will Keep Her from Selling Her Small Business
Julie smiled and said . . .
This investment is going to pay off in a huge way.
Julie has good reason to smile. She owns a small business that is growing every single year.
Julie’s had big eyes for growth since the first day she bought her business.
But there’s a problem, a big one, and I’m afraid her smile is going to disappear when I tell her about it.
This Way to the Exit
This next part might seem like a strange diversion, but it’s key to understanding Julie’s problem – a problem she shares with many other growth oriented small business owners who fail to create transferrable value in their business.
Here’s what Julie is missing: most small businesses are sold with a value calculation based on Seller’s Discretionary Earnings times a multiple.
SDE X Multiple
Let’s break that down:
- SDE is the extra cashflow generated by a business that is not needed to run the business itself. Owner salary and benefits, bottom line profit and other items get put in the SDE bucket. (Look here if you don’t understand SDE).
- That SDE figure then has a multiple applied to it. The multiple is determined by several factors including industry type, size of business, etc. The average national small business multiple is around 2.5.
So, to dangerously oversimplify small business valuation, let’s say that the average small business is valued with this calculation:
SDE X 2.5
In Julie’s case, she’s looking at a current three-year average SDE of around $100,000.
If we apply the average multiple of 2.5, we end up with a value equation on Julie’s business that looks like this:
$100,000 (SDE) x 2.5 (multiple) = $250,000
So, Julie’s business is worth $250,000 . . . and that’s a problem because Julie wants at least $600,000 when she exits her business.
That’s a $350,000 gap between current estimated value and her exit goal.
That’s a big divide, but maybe not as big as it seems.
If you look closely at the financials, you see that Julie’s business is capable of producing the $240,000 SDE she needs to justify the $600,000 sales price she wants. She can get there . . . if she can just stop “investing” in growth.
Last year, Julie “re-invested” $100,000 back into the growth of her business. If that revenue had been allowed to hit her SDE instead of being spent, she would have been much closer to her goal.
Current: $100,000 (SDE) x 2.5 (multiple) = $250,000
Without investment expenses: $200,000 (SDE) x 2.5 (multiple) = $500,000
That $100,000 would have made a huge difference in her SDE value calculation, but ironically, Julie’s making these investment decisions to “increase the value” of her business.
Why does Julie keep reinvesting? Because she believes . . .
If I grow my business, I’m increasing its value.
And she’s right . . . well . . .kind of. . .and only sometimes.
Growth of revenue by itself does not increase a small business’ value.
(If you’ve got big eyes for growth, read that last line again and let it soak in.)
However, if Julie converts the revenue into a higher SDE, she will see her business value increase. For example, if her investments result in an SDE of $400k . . .
$400,000 (SDE) x 2.5 (multiple) = $1,000,000
But growth only equals increasing value if Julie stops, or at least slows, the cycle of investment. If she’s always investing (and reducing her SDE by doing so) she’s never going to experience the actual results that create increased transferrable value.
If she wants to create value, Julie needs to stop investing.
“But Growth is My Job”
Actual job title aside, Julie views her current job as “making the business better.” To do that she . . .
- Solves problems
- Makes investments
- Finds growth
As often as not, these activities create an up-front loss in the business. For example, she . . .
- Hires a new employee to pursue an opportunity, but it will take 6-9 months to start seeing that new income (if she’s right about the new opportunity.)
- Institutes a new accounting software to increase employee efficiency (but it’s going to require a fair amount of uncompensated training to get staff up to speed.)
- Commits to an office space expansion (which will offer a payoff, in the second half of the 5-year lease).
Wait . . . Aren’t Investment’s Addbacks?
Let’s go a little further down the rabbit hole and address a potentially legitimate, if muddy, technical argument.
When a buyer (or business broker) looks at a business, they usually go through an exercise called “recasting the financials.” This process is designed to allow a potential buyer to try to get a sense for the SDE of the business being examined.
To do that, they find a list of “add-backs” to create the SDE. An add-back is an item that hits the income statement as an expense but is in reality an element of SDE.
As a simple example, say the current owner has the company pay $12,000 towards their health insurance coverage. Even though that expense appears in the same category as the other employee’s insurance costs, it’s actually an addback.
Say the buyer has their health insurance covered by their spouse’s employer? Or maybe they don’t care to have health insurance at all. Regardless of the situation, the money spent by the business on the owner’s health insurance is discretionary spending, or SDE. So, it’s an “add-back.”
$100,000 (SDE) + $12,000 (health insurance addback) = $112,000 (New SDE)
$112,000 (New SDE) x 2.5 (multiple) = $280,000
Add-backs add value, but add-backs can get fuzzy.
I haven’t bought toilet paper at home for years.
(Yep, a small business owner really said that to me as she advocated for an add-back from her office supply expense.)
There are add-backs, and then there are add-backs. The owner’s benefit of the potential “add-back” needs to be clear and documentable.
And Investments Can Be Add-Backs . . . Occasionally
Investments that qualify as “one-time expenses” can be add-backs.
For example, if an owner invested $50,000 last year into a new piece of software that will help them pursue a service expansion in their business, a broker might reasonably “add-back” those costs to last year’s SDE. Since a new owner wouldn’t have that expense in the future, a broker might well argue that it’s a one-time investment expense and should be added back to last year’s results.
However, adding-back “investments” in a small business is rarely as clear-cut as it is in the software example above. Sure, if you buy a new software program, specifically designed for a future service expansion then an add-back makes sense.
But what if . . .
- The software expense is a required upgrade on an existing software . . .and moreover is an expense that can reasonably be expected to reoccur every three years?
- Half the “software” expense was staff training cost, and the new owner will have to incur this training expense with each new hire – potentially increasing their future costs?
You get the idea.
Most buyers reasonably expect an add-back to be clear.
And most of Julie’s investments are not. So even as she invests in growth to increase value, that higher value eludes her because she can’t add-back those expenses.
Why Can’t She Sell the Future Payoff?
“Wait a minute,” you might say, “why can’t she expect a buyer to assume the future increased SDE results and pay her accordingly?”
Why isn’t it enough that she’s making the investments?
Because even though Julie is good at making investments in her business, like most small business owners, she’s not perfect.
Often her investments pay off. $25,000 invested creates a $15,000 annual profit pay-off each year. A great ROI after a few years. That’s a win. But they don’t all look that good.
- The new department she started with three new hires . . .only to shut it down 9 months later.
- A strategy to expand to a 2nd location, that she pulled back from, but not before she’d spent tens of thousands on the effort.
The list goes on and on. Some of her investments pay off, some don’t. And understandably, a buyer is unlikely to pay for outcomes that can be proven.
And how does Julie prove the value of her investments?
By pointing to the returns those investments create . . . as documented in her SDE.
Do you see the circular problem with Julie’s big eyes for investing in her business?
Let the Profit Survive Your Good Intentions
Julie has a growth and development mindset, and that has served her business well. But now that she wants to sell the business she needs to stop, or at least dramatically slow down her re-investment approach.
Basically, she needs to allow the previous investment decisions she’s made the time they need to pay off. She needs to let those results hit her SDE. If she doesn’t, it’s going to be incredibly difficult for her to prove their value to a potential buyer.
This basic “sell a business” truth can be challenging for small business owners to see, especially for those that have big eyes for growth.