Every entrepreneur that’s buying a business for the first time is faced with the challenge of determining what the fair price for a given business is. Whether other reasonable parties will disagree, business valuation is equally both an art and science.  

 

Commonly, small businesses are valued at a multiple of cash flow that ranges from one(x) to four (x) times.  

 

There are two important questions that have to be asked:

Defining Cash Flow

There is a broad-based agreement among practitioners that the cash flow of a business is equal to:    

 

Cash Flow =  

 

Net Income (Per the books or tax returns) +

Owner’s Salary/Payroll Taxes (If deducted to arrive at net income) +

Owner’s “Perks” (e.g. Auto payments, travel and entertainment, personal insurance [health, life and auto], other personal or discretionary expenditures) +

Depreciation, Amortization (These are non-cash expenses that did not require current period cash outlays) +/-

One-Time Expenses/Revenues (Non-recurring, unusual expenses or revenues that are extremely unlikely to occur again next year or thereafter) +

Interest Expenditures (Interest is an “add-back” because we seek a bottom-line figure representing cash flow that’s available to the prospective owner)

 

Defining Seller’s Discretionary Cash (SDC)

One misconception is that seller’s discretionary cash or SDC refers to gross sales or revenues, but this is incorrect. Seller’s discretionary cash represents the amount of cash flow that’s available to a new owner (after all expenses but before income taxes) to accomplish three things:  

The buyer is seeking a figure that consistently represents the cash flow that’s available to him or her when he or she starts operating the business full-time – 40 to 60 hours a week minimum.