Gray Matter Musings

Week 3 starts now…

Revenue is a term that entrepreneurs hear endlessly throughout their careers. Many presume that revenue is the perfect marker for seeking out a profitable business to acquire. After all, if you have lots of revenue coming in, you should be in great shape, right? While revenue is important, businesses operate with considerable expense and managing both revenue and expenses is critical when operating a profitable and growth capable business. Furthermore, as entrepreneurs, we want to be rewarded for our efforts and the risk we take on, often in the form of salary or discretionary earnings. Whether we put this into our pockets or back into the business, ensuring there is room to prosper is key to defining a suitable acquisition target.

Enter “seller discretionary earnings”, which might also be called “cash flow” or “adjusted EBITDA” amongst some sellers and brokers. Deibel’s method suggests that rather than looking at revenue as an indicator of a businesses health, it is far more beneficial to understand what the current business owners enjoys in seller discretionary earnings (SDE). In fact, the underlying secret in acquisition entrepreneurship is that many businesses simply aren’t worth what existing owners might believe. Most M&A and business brokers use a simple “multiple” method when valuing businesses and those multiples are based on SDE, not revenue. These multiples can vary based on industry and business type, though they may commonly range from 3 to 7 (some can be lower and some much higher) for most main street and mid market ventures. This simple method means that business A, with $250,000 in yearly SDE at a multiple of 4 is valued at roughly $1,000,000 in a sale scenario. As Deibel shares, “by measuring an acquisition target by SDE instead of revenue, you are defining the search by the cash flow it will provide and the transaction price you can afford” (Deibel, 2022a). (Buythenbuild.com provides a simple tool free of charge to run these models).

Now, we understand that revenue isn’t the primary method for valuing a potential business acquisition. In fact, it is as simple as the purchase price = SDE X the appropriate multiple (PP=SDE x M). Another quick insight provided tells us that SDE should typically range from 10 to 20% of revenue, which gives us a method of fact checking the business to ensure the revenue aligns. This summary of basic information gives entrepreneurs even more ammunition to add to their target statement (what they are looking for in a business) and allows us to calculate the type of company we can afford to purchase based on our preferred capital/financing method.

Thus, we are ready to begin the search! While the easy option is to google “businesses for sale”, Deibel warns against this method as a primary means of searching. “Skip the internet” is a motto he follows closely, preferring instead to plug directly into those with the most recent and inside information, brokers (Deibel, 2022a). By swimming upstream to the head of the river, entrepreneurs can bypass the clutter and reach out and connect directly with the brokers charged with managing these listings. That may seem like a challenge, but I have personally connected with 3 brokers since beginning this book with some success. Rest assured, brokers are never scared of adding potential buyer contacts to their rolodex. (if those still exist)!

Stay tuned next week as we dive into the art of analyzing the financials of a prospective target and navigating the deal process!


References:

Deibel, W. (2022a). Buy then build: How Acquisition Entrepreneurs Outsmart the Startup Game.