If you’re a first-time buyer or seller, it’s important to understand the terms you’ll hear from your broker, lender, and other professionals during the sale. Below are some of the most important terms.
Add Back: Add backs are expenses that the current business incurs that won’t pass on to the new owner. They might include employing relatives in the company at higher than market salaries or paying for the owner’s phones, health insurance, or personal vehicles. Applying add-backs and other kinds of adjustments help normalize a business’s earnings from a new owner’s perspective. This is also always based on the business being purchased by a single owner.
Earnings Before Interest Taxes Depreciation and Amortization (EBITDA): EBITDA is a measure of a company’s overall financial performance and profitability; it’s used as an alternative to net income in some circumstances. The usual shortcut to calculate EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT) and then we add back items such as depreciation and amortization. It’s an important figure for a buyer in the due diligence process. The full formula for EBITDA is calculated by taking the net income of the business and adding the interest, income taxes, depreciation, and amortization to that net income.
Discretionary Earnings (DE), Seller’s Discretionary Earnings (SDE), Owner’s Benefit (OB), and Cash Flow are all terms used to refer to the amount an owner can expect to be able to take out of the business each month or annually. It’s the bottom line earnings for most buyers as they determine what a business is worth to them. The figure must be enough to cover the debt of buying a business and the salary of the owner or person hired to run the company. The financial equation would be:
EBITDA+ Owner’s Salary + Fringe Benefits (Add backs) = SDE, DE, OB, Cash Flow
Due Diligence: The process of investigating a company’s business, legal, and financial position in advance of a deal, along with any contingencies that might affect the sale. We recommend that a buyer locks in a deal with a seller (by obtaining a binding letter of intent or signed Asset Purchase Agreement) before beginning due diligence. This makes the most effective use of time for both the Buyer and Seller. Otherwise, legal and accounting dollars could go to waste without a firm agreement to move forward.
Gross revenue, or sales, versus net revenue or sales: Gross revenue measures a company’s total income from sales without returns or discounts. Net revenue refers to the total amount of money that the company collected after adjusting for returns and other allowances.
Gross profit versus net profit: Gross profit is the company’s gross sales minus their cost of goods and materials without subtracting the manufacturing or production expenses. Net profit is the gross profit minus the expenses of all business operations. The net profit is going to be a much more realistic representation of a company’s profits. Having both figures available can help a buyer understand how expensive it is to produce a company’s goods or services.
Letter of Intent: The easiest way to understand the Letter of Intent is to think of it as a summary of the terms for an offer that a buyer would like to make. LOI’s are typically fewer than five pages long and are written with the intent to use these terms in an eventual purchase offer that will need to be submitted and agreed upon at a later time in a deal. It can be legally binding or non-binding, but it does declare the intent of the two parties to do business. The non-binding LOI is different than an Offer Letter, which can be legally binding and further lays out the terms of purchase.
Multiple: A multiple is a ratio calculated by dividing the price or estimated value of a company by the discretionary income value found on the financial statements. If a business is priced at $5 Million and the discretionary income is $2 Million, the multiple would be 2.5. That means the business would be priced at 2.5 times discretionary cash flow also known as discretionary income. However, there are many factors taken into consideration when creating this multiple. A buyer needs to understand if the multiple is industry specific or if it is based on SDE, EBIT, or if it includes or excludes the owner’s salary. Other factors to consider when deciding a multiple include the size of the business, as well how the business will be financed by a buyer either through bank financing, investor financing, seller financing or self-financing. This is where the multiple can be confusing for many buyers.
Non-Disclosure Agreement: When you have an interested buyer in a business, a broker will often have all parties sign a legal agreement that agrees to protect and keep confidential any sensitive information they learn. A confidential nondisclosure is often referred to in its abbreviated form (NDA) and is mostly interchangeable with “Confidentiality Agreement.”
Opinion of value: A broker’s estimate of what a business would sell for in the current market. A Business Appraisal is a paid service offered by licensed business appraisal professionals. Business appraisals go more in depth and analyze economic and industry conditions, business financials, and the tangible and intangible assets of the business. Using this analysis and the appropriate valuation method, a Certified Valuation Analyst (CVA) will compile their findings into a detailed report on the value of the business.
Owner or Seller Financing: The owner agrees to hold part of the debt for the new owner, deferring their payout over time. When a Seller holds a note, the buyer feels that the Seller shares in the risk of the future success of the business. This mitigates the Buyer’s risk, helps with cash flow, and the future owner has a vested interest in the continued success of the business.
Private Equity: Private equity firms are investment management companies that provide financial backing and make investments in startup or operating companies. They usually look for companies in strong financial positions. Their goal is to encourage the business to grow further.
Searchfunder: A buyer that pools and bundles investor money together to purchase a business. They often source the money through private equity groups, private investors and family investment offices to see if they will help fund a transaction. In exchange for funding, investors obtain equity in the deal. Searchfunders might also invest some of their own money into a deal but will always obtain equity in a deal as compensation for sourcing the funds. Oftentimes they receive the opportunity to run the business and be the face of the business.