Business owners who have never sold a company or raised capital, the prospect of speaking with M&A advisors and business brokers for the first time can feel daunting. While it’s easy to procrastinate or refuse to think about selling your company, preparing for the next stage of your business is just as essential as running your core business. Even if you’re not looking to transact in the near term, brokers and advisors can help you understand what to do now to guarantee more value in a transaction years down the road.

Here are five questions business owners can expect on an introductory call with a business broker or M&A advisor:

1. “What does your company do, and how are you differentiated from your peers?”

An advisor will ask you to explain your current position in the marketplace and your plans to grow the business. Be prepared to talk about how you distribute your products or services, how your team is organized, how you generate revenue, and any unique strengths of your company or business model.

2. “Why are you interested in selling your business or raising capital and what do you plan on doing afterwards?”
This is the first and most important question brokers and advisors will ask.  It is also the first question potential buyers and investors will ask. 

Before speaking to an M&A advisor or broker, be sure to think about what you’re hoping to get out of a transaction — whether now or in the future. Is your interest based on the current market, a personal situation such as health or retirement, growth opportunities in the industry, or a combination of factors?  How long do you plan on staying with the company after the acquisition?  Are you planning on getting the “hell out of there” or willing to stay on for a period of time?  The longer an owner is willing to stay with the company typically results in a great valuation for the business.

3. “Do you have a valuation or capital amount in mind?”

It’s OK if you don’t — but if you do have a specific amount in mind, advisors will want to understand how you came to that number. We ask this question because, more often than not, the business owner is unsure of the standard valuations in their industry.  Many owners will base their valuation purely on the dollar amount they want or figures they have heard at cocktail parties.  However, numbers can vary widely even within a specific sector.

4. “Besides an attractive valuation, what would a dream deal look like in your mind?”

Some owners are simply tired of the headaches of owning a business, but still would like to stay on with the business; others may want to leave but have their management team stay on. Are you willing to sell your company to someone who may overhaul your entire business model or start with layoffs, or is employee security your top priority?  Whatever your answer, this question reveals other tangible and intangible items that are important to the seller.  This information not only helps to further qualify the prospect, but gives the advisor further insight regarding how the prospect thinks. 

5. “May I see your last 4 years of financials.”

M&A advisors and brokers will always ask for the financials.  It is impossible to value a business without seeing any financials.  The reason most advisors want at least four years is to see any trends in the business whether it being positive or negative.  In addition, all good advisors will apply a weight to each year’s results when calculating revenue, cash flow, EBITDA, etc…   

Most businesses are valued based on a multiple of EBITDA or seller’s discretionary earnings plus inventory.  There may be some other factors involved in the valuation such as current value of equipment, but this usually only comes into the valuation when it is a business with a substantial amount of equipment such as a heavy construction or manufacturing business.  For this article we would like to focus just on EBITDA and seller’s discretionary earnings. 

EBITDA and seller’s discretionary earnings are very similar, but seller’s discretionary earnings simply takes it one step further.  Most people may know that EBITDA stands for earnings before interest, taxes, depreciation, and amortization.  Seller’s discretionary earnings is EBITDA plus owner’s salary and personal expenses or as we like to call it “non-business essential” expenses. 

EBITDA is most often used when valuing mid-market business whereas seller’s discretionary earnings is used when valuing main street businesses.  The reason for this is that most small main street business owners live through their business.  By this I mean they may take business trips and stay a few extra days as a vacation or employ family members that they pay a salary significantly above the market average due simply to being family.  There are also many non-business essential expenses they run through the company to minimize taxes that another potential owner would not incur.  For what might be obvious reasons, we will not discuss these in this article.

Even though EBITDA is the most commonly used multiple factor for valuations of mid-market businesses there are a lot of times when seller’s discretionary earnings should be used instead.  Let’s look at an example:

1. A restaurant has EBITDA of three million, the owner is semi-absentee (only looks at reports), pays herself a million dollars a year in salary and has travel expenses of $500,000.  They do not cater nor offer delivery.

2. The same restaurant has EBITDA of three million a year, the owner is full-time active in the business, does not pay herself a salary, and only has minimal travel expenses of $5,000. They do not cater nor offer delivery.

Simply using EBITDA the value of these two businesses would be the same. However, we all know this does not make logical sense. 

So what should be done to adjust the valuations of the two examples above? A business valuation expert would evaluate the market and determine how much it would cost to replace the current owner and why there was such a high travel expense in the first example when they do not cater or deliver. This is when you would use seller’s discretionary earnings as the multiple factor instead of just EBITDA.

If the current owner only looks at reports, such as in the first example, they would probably not need to be replaced and therefore, no employee expense.  If they do not cater or deliver one would realize the vast majority of the $500K in travel is a non-business essential expense. In this case we would add back the million dollars in owner’s salary and usually 90% of travel expense to EBITDA so now the seller’s discretionary earnings is $4.45M. 

In the second example where the owner does actively run the business one you would need to consider their duties and determine how much it would cost to hire an employee to perform these same duties.  If it would cost $200,000 to replace the owner then you would subtract this from her current salary. However, in this case where the owner doesn't take a salary you would subtract the $200,000 from EBITDA. Since there was minimal travel expense there would be no need to adjust those numbers.  Therefore, in the second example the seller's discretionary earnings would be $2.8M compared to the $4.45M in the first example.

These two businesses were valued the same when we simply use EBITDA.  However, after digging in the business and financials a little deeper we realize there should be adjustments made. These adjustments show the first business should be valued higher than the second.  No two businesses are exactly the same, but we do see a lot of situations like the one above where seller’s discretionary earnings should be used as the multiple factor for a mid-market business instead of just EBITDA.