Since the goal of owning a business is to earn money, and buyers are seeking income, most businesses are sold for a multiple of earnings. But what does that mean?
You might hear someone say that their friend sold their company for 5 times their earnings, but if you look at comparable transactions, you will see that most small businesses sell for 2-3 times their earnings. Why the difference? It’s the definition of “earnings.” Your friend may have sold at 7 times EBIT (earnings before interest and taxes), while the other businesses may have sold for 3 times DE. (Discretionary Earnings) Discretionary Earnings add back the owners’ salary, interest, depreciation, amortization, and personal or discretionary expenses. Discretionary expenses might include personal vacation, country club memberships, personal boats, etc.
There are many databases that track the price paid for businesses as a multiple of earnings. But knowing what level of earnings they track and calculating and comparing your business to the correct level of earnings is where the problems arise. Here are some of the common levels of earnings that the most popular databases use:
DE (Discretionary Earnings, but also known as SDE (Seller’s Discretionary Earnings), Owners Income, Owners Benefit, and many others)
EBITDA: Earnings before interest, taxes, depreciation, and amortization
EBIT: Earnings before interest and taxes
How to calculate each of these correctly would take far more space than this article will allow. But most main street businesses are priced as a multiple of DE, while most larger transactions (also known as Lower Middle Market) transactions are valued as a multiple of EBITDA. So, when your friend says I just sold my company for 5 times earnings, know that the multiple is only part of the equation.
PRO TIP: Do not look at the earnings multiple from the website’s asking prices. A much better indicator of value is the multiple paid on a business that really sold, better yet, where the data comes from a reliable source, such as a business broker or lender, not an individual seller who perhaps didn’t know how to compute their earnings correctly.
