THE FUNDAMENTALS
Whether you own a business or hope to buy one, good decisions start with shared vocabulary. Here are the core concepts we walk every client through, explained in plain English.
MEASURING EARNINGS
Buyers do not buy revenue. They buy cash flow. The two most common ways to measure it are seller’s discretionary earnings and EBITDA. Which one applies depends mostly on the size of the business and whether an owner is running it day to day.
SDE = EBITDA + owner’s compensation + owner’s benefits
That is the whole difference between the two. EBITDA assumes someone else is doing the owner’s job and being paid for it. SDE credits that salary and those benefits back to the owner, which is why SDE is the larger number and why it is the right measure while an owner is still running the business day to day.
Seller’s discretionary earnings is the total financial benefit to one full-time owner-operator.
Earnings before interest, taxes, depreciation and amortization assumes the owner is replaced by a paid manager.
HOW A RECAST WORKS
Most owners run their books to minimize taxes, not to show a buyer what the business really earns. A recast rebuilds the financials so a buyer and lender can see the cash flow a new owner would actually receive. Every add-back must be documented, or it will not survive diligence.
| Line item | Amount |
|---|---|
| Net income on the tax return | $180,000 |
| + Owner salary and payroll taxes | $120,000 |
| + Owner health insurance | $18,000 |
| + Depreciation and amortization | $25,000 |
| + Interest expense | $12,000 |
| + Personal vehicle run through the business | $9,000 |
| + One-time legal settlement | $15,000 |
| Seller’s discretionary earnings (SDE) | $379,000 |
| Less owner salary, payroll taxes and health insurance | ($138,000) |
| Adjusted EBITDA | $241,000 |
The last two lines apply the formula from the top of this page. Take SDE and remove the owner’s salary, payroll taxes and health insurance, and what is left is adjusted EBITDA, the number a lender uses when the business is priced on a management team rather than an owner.
What does not count as an add-back: recurring expenses the business needs to operate, deferred maintenance, cash income that was not reported, or costs that will simply move to the new owner. Aggressive add-backs are the fastest way to lose a buyer’s trust.
VALUATION
Most small businesses are priced as a multiple of SDE. Larger businesses with a management team in place are usually priced as a multiple of EBITDA. The multiple reflects risk: size, growth, customer concentration, owner dependence and how clean the books are. The owner’s hours matter too. The more the owner personally works in the business, the closer the deal is to buying a job, and the lower the multiple a buyer will pay.
| Where the business sits | Typical multiple | Why |
|---|---|---|
| Owner works full time in the business | About 1.0x to 1.5x SDE | The more hours the owner personally puts in, the more the buyer is purchasing a job. Most buyers do not want that, so the multiple sits at the low end. |
| Typical healthy small business | About 2x to 3x SDE | The most common range once the owner has a small team around them and the business does not live or die on the owner personally. |
| Larger business with management in place | About 4x to 4.5x EBITDA | Once earnings pass roughly $1 million of SDE, size and a real management team lower the risk. Multiples expand from here depending on the industry and how much management stays after the sale. |
Ranges move with industry, growth, customer concentration and how much management stays after the sale. These are general figures, not an appraisal of any one business.
Asking price is where the conversation starts. Value is what a qualified buyer will pay and, just as important, what a lender will finance. Sellers sometimes set prices a bank cannot support. Lenders generally want the business’s cash flow to cover its annual debt payments by at least 1.25 times, the debt service coverage ratio. That single rule puts a natural ceiling on the deal, no matter what the asking price says. Try the math yourself.
The defaults are illustrative: $160,000 of SDE less a $60,000 salary for whoever runs the business. If you plan to operate it yourself, enter your own salary in that field, because lenders want to see a market salary for that seat either way. Every lender also weighs collateral, credit, seller notes and working capital, and each has its own box. Confirm terms with your own lender.
The buyer purchases selected assets: equipment, inventory at an agreed level, goodwill, the name and customer relationships. Liabilities, liens and most of the company’s history stay behind with the seller. That is why most small business deals are structured this way, and why buyers prefer it.
The buyer purchases the company itself and steps into its history and obligations. It is used when value is tied to things that live with the entity, such as licenses, permits or contracts a fresh company cannot simply pick up. A bar’s liquor license is the classic example. It can be cleaner for the seller, and the tax outcomes differ for both sides.
Structure changes the taxes for both sides, sometimes significantly. Talk the structure through with your own CPA and attorney before the letter of intent is signed.
DEAL TERMS
A short, mostly non-binding document that sets price, structure, timing and key terms. Once signed by both sides, the business typically goes under exclusivity while the buyer completes diligence.
The buyer verifies financials, tax returns, bank statements, contracts, leases, employees and operations. Budget 60 to 75 days. Clean, organized records make this phase far easier.
The binding contract. It covers price, allocation, representations and warranties, indemnification, non-compete terms and closing conditions.
Part of the price paid to the seller over time, like a loan from seller to buyer. It shows the seller believes in the business and often helps the buyer qualify for bank financing.
A portion of the price tied to future performance. Useful when buyer and seller disagree on value, but terms must be defined carefully.
Most deals include a period, often 30 to 90 days, where the seller helps introduce the buyer to customers, vendors and staff.
FINANCING
The most common way first-time buyers finance a small business acquisition. Loans up to $5 million, often with a 10 year term and as little as 10% equity injection from the buyer.
The buyer’s cash into the deal. Lenders want to see proof of funds early, which is why serious buyers lead with it.
Cash flow available to pay debt divided by annual debt payments. Lenders generally look for 1.25x or higher after paying the new owner a reasonable salary.
An early read from a lender on how much a buyer can borrow. It tells sellers and brokers the buyer can actually close.
Loan programs and limits change. Buyers should confirm current terms directly with an SBA lender.
GLOSSARY
Expenses on the books that a new owner would not incur, added back to show true earning power.
Confidential information memorandum. The detailed marketing package a qualified buyer receives after signing an NDA.
Non-disclosure agreement. Protects the seller’s confidential information before details are shared.
Current assets minus current liabilities. Some deals set a target level the business must deliver at closing.
How much revenue depends on a few customers. High concentration usually lowers the multiple.
How much the business relies on the owner personally. Less dependence means more value and easier transfer.
Financials adjusted to remove unusual, one-time or non-market items so a buyer sees a typical year.
A neutral party that holds funds and documents until all closing conditions are met.
How the price is divided among equipment, inventory, goodwill and other assets. It affects taxes for both sides.
An agreement that the seller will not compete with the business for a set time and area after the sale.
This page is general education, not legal, tax or accounting advice. Taxes and proceeds depend on deal structure and your situation, so sellers and buyers should consult their own CPA and attorney.
LET’S TALK
Send your financials and get a confidential valuation, typically within a day.
