Your online business is likely your MOST VALUABLE ASSET. And calculating its value is critical to setting goals and knowing your net worth. “But I never plan to sell” is something we hear often…and as entrepreneurs most of us @ QLB have said the same thing. Yet each of us has built, bought and sold our own online business…even the ones we never planned to sell.
When I sold my web-based business in 2010 I was a novice. With what I know today if I could go back in time I would have planned my exit and likely sold my business for 2-3x more than I did. Instead…I waited until I was emotionally tired of the business, and sold it when the numbers were half what the once were. Not smart.
Don’t be like me…listen to this Podcast and implement our suggestions. You risk everything building and running your business, and you should get maximum value if/when you exit. The first step in getting max value is understanding the valuation process and being able to calculate your Seller’s Discretionary Earning (SDE).
Mark and I joke about falling asleep in this podcast due to some of the content…we’re joking…and the material here is incredibly valuable.
- Learn the basic web based business valuation formula.
- Get to know what parts of a business swing the value range up or down.
- Net Income, plus Add Backs = Seller’s Discretionary Earnings (SDE).
- What’s an Add Back? Learn what are acceptable and unacceptable add backs.
- How add backs boost the value of your business.
- Using accrual accounting vs. cash for COGS…critical to understand for both buyers and sellers.
- Learn the typical multiple (value) ranges for an online business.
- Why a larger business fetches a higher multiple than a smaller ones.
- Inventory is SOLD SEPARATELY. If you own a physical products business, while listening to this Podcast your inventory levels will change. Including it in the list price artificially inflates the multiple of the business and results in an unstable list price.
Mark: Joe how are you?
Joe: I’m doing great Mark. How are you, sir?
Mark: Good, good I heard you explored the depths of the mysterious Vendor Central recently?
Joe: Yeah. Listen, the good, the bad, the great Amazon sellers that we know…that we’ve talked to over the last decade for the vast majority they all say no way don’t lose control to Vendor Central, don’t do it, don’t do it. When you when I went to IRCE in Chicago in 2015 I talked to somebody that was an ex-Amazon Vendor Central manager, he’s the first person that ever told me that it was great and that he could double somebodies business using vendor Central and I believed him. We never reconnected afterwards; this guest today is the second one. His name is Fahim Naim, he’s from…originally he was an Amazon Category Manager and he left and went and started his own company called eShopportunity. And he gave me one example and this is a huge one so don’t get scared away if you’re doing $50,000 a month in revenue listeners. His first client he took and quadrupled the revenue in Q4 alone by using Vendor Central Tools. So he took it from 4 million dollars a quarter to 16 million by using Vendor Central.
Mark: Holy cow.
Joe: A huge growth. Huge growth. So that alone is reason enough to listen. And as firsthand information from somebody that’s actually done it, and seen it, and uses it services and he’s quite honest and open about it. It’s not for everyone and it’s not take a leap of faith and you no longer run Seller Central anymore. It used to be that way and I think that’s why people feared it. He’s got some great ideas on how to take just one skew and test it out and slowly move over and things of that nature. I’ll make a whole lot of sense if I were a seller, if I were a buyer, I would look very very closely at Seller Central.
Mark: Fantastic. Well, I can’t wait to get into this before we get into the episode though I’m going to make a public plea to the listeners out there. I want to know what conferences you guys go to because we like to go to conferences. We’d like to meet you so send me an e-mail at [email protected] with your favorite conferences to go to throughout the year and I know that’s completely unrelated to what we were just talking about but you mentioned the IRCE and it just sort of triggered that. All right with that, I’m actually anxious to hear this because like you I’ve heard the same sort of feedback from most Amazon Sellers. They’re saying no way, I don’t want to do it but it’s really hard to ignore quadrupling revenues by jumping over there so let’s get into the episode and hear what he has to say.
Mark: Hey Joe how are you?
Joe: I’m good Mark. How are you doing today?
Mark: I’m good. Today we have an unusual guest at least for our podcast.
Joe: That’s what my wife calls me unusual.
Mark: Well that’s because you are the guest right? And in Quiet Light Podcast fashion, I’m going to have you introduce yourself to all of our listeners who have no idea who you are. Actually, they know you probably better than you may know yourself at this point because they’ve listened to you so much but I want to provide just a quick introduction for yourself.
Joe: Wow this is how our guest feels. Now I’m on the spot. I hadn’t thought that you were going to do that to me. But who am I? Self-employed since 1997, I’m kind of an old guy. Can you see that? A gray hair. 52 years old. Built box sold own online businesses, sold my last e-commerce business for a company called Quiet Light Brokerage. Jason here was my broker; you were the first guy I talked to. I loved the process in transactions so much. I reached out to you and six months later I said you know I’d love to be a broker and you said yeah let me talk to Jason. Jason thankfully said yeah talk to this guy. I came on in early 2012. You and I are now partners now. You’re the majority and I’m just a small guy in the process but since then closed what approaching 30 million in total transactions might get 50 by the end of this year depending upon what happens, been around the block a little bit; lots and lots and lots of transactions of all shapes and sizes.
Mark: And I think it’s safe to say that you have built a name for yourself in the industry quite a bit. People know you. And I think for the first time in the history of the company we had a client you are working with and your plate was getting a little bit full so you thought about trying to hand him off to me and he said “No, I don’t want to work with the founder of the company. I’d rather work with you, Joe.” And that’s never happened. I’m totally happy about that though not that I don’t want to be working with a client but it just goes to show the reputation that you built in the industry.
Joe: Or how your represent…reputation is now destroyed. I’m not sure.
Mark: Probably, now the word has gotten out. Well, he’s not actually as good as we thought compared to Joe or Jason or these other guys. Well, we did a podcast episode a while ago with Chuck Mullins and we’re going to be doing more of these words “Meet the Broker”. We also did one with Jason. So those you can find back in the podcast history but we obviously don’t want to just talk about you and your background as fascinating as I’m sure that might be. You’ve got lots of years of wisdom to share with everybody. But we want to actually talk about a specific topic and I…and today we’re going to talk about specifically how to calculate the value of your web based business or any web based business and what is the process that goes on behind the scenes to calculate that value. I know you gave a presentation recently, I think back in January out in California on this and it turned into a lot of questions about the actual valuation process. Like just the formula itself and how do we arrive at a certain number. So for those listening, we are going to talk you through this. But for those that are watching we will have something up on the screen a presentation that you can follow along. If you’re listening in your car and you want to come back later you can find this on our YouTube Quiet Light Academy or on our podcast page at Quiet Light Brokerage. So tell us a little bit about the presentation Joe and how you kind of spent so much time just on the first half of this presentation.
Joe: Yeah the presentation is really supposed to be about you know the pillars of growth. There’s generally four of them and I put planning in there as a fifth. It was supposed to be about the pillars of maximum value but in order to get to that, I had to talk about how to calculate your seller’s discretionary earnings in the value of your business and then it got into add backs. I really was going to do about a five minute presentation on that, about a 40 minute presentation on the rest, and then 30 minutes at Q and A. It turned into about 45 minutes of Q and A alone on calculating the value, in particular, the add backs. What was acceptable, what was not, and then the multiples and ranges depending on the net. So today in this first episode I want to touch on how to calculate the value of your business and then we’ll get to the four pillars of value after that. So simply put Mark it’s an easy formula. There should be no confusion about it. If you’re looking at the screen there trailing 12 months seller’s discretionary earnings times the multiple equals the list price of your business, simple; right? 300,000 in discretionary earnings times three you got a list price of a business of 900,000 in the key plus the landed cost of good saleable inventory on hand at the time of closing that. All of that language is really critical. Now I’ve been a guest on podcasts as well as you on other people’s podcasts and we’ve talked about this formula at the beginning of the podcast and then literally 15 minutes in the host will say “So how do you calculate the value of your company again because it’s simple but really-really confusing.” So I want to go through it. So we know this formula it’s up to the screen again for listeners it’s your seller’s discretionary earnings for your trailing 12 months times A multiple equals the list price plus the inventory if you’ve got a physical products business. But the problem here is calculating the seller’s discretionary earnings. We’ll get to how to figure out what your multiple is but the most important thing is how to calculate seller’s discretionary earnings. So it’s up there on the screen now. It’s simple if you use accounting software which is kind of important. Right, Mark?
Mark: Very very very much important, yes.
Joe: One of the four pillars. It’s net income plus add backs equals your seller’s discretionary earnings. So if you run a profit loss in Quick Books or Xero it’s going to give you a net income number on the bottom. But every entrepreneur, for the most part, sometimes partnerships have better books…cleaner books. But most entrepreneurs, if you take a small salary, if you have a car that you ride after the business, you have your mobile phone as run through the business, all these things are personal in nature and then there’s some one-time expenses as well. Those are considered add backs. So if you run a business and your net income is zero, that doesn’t mean your business is worth zero. You could take a hundred thousand dollar salary and that’s an add back as it’s a personal benefit. Makes sense?
Mark: Makes sense. But I’m going to back up just a minute here.
Mark: Go back to the previous slide.
Mark: Now where we’re talking about the formula that we’re using to calculate value. In that formula again, just to drill it into people’s heads, it is the trailing 12 months seller’s discretionary earnings which is close to a bit in most cases but not always. So we take that we times it by a multiple and that’s where we come up with the asking price or the estimated value of a business. But let me ask you or to give an objection that we hear a lot from sellers when they see this. Isn’t this too simple, what about all the other aspects of their business? What about the unique relationship that they have with the supplier or the upward mobility or upward scalability of the business and the trajectory of it? Isn’t this just looking at the income only and not paying attention to all those other things?
Joe: Yes and no. Right? And that’s the answer is that we come up with a value range it’s not a firm number, it’s a value range and your business may swing in that range depending upon some of those things. If you’ve got a five year old business and you’ve got 30% year over year growth versus an 18-month old business, one is more valuable than the other. If you’ve got a patent on a particular skew that you have that prevents other people from competing with you that brings more value. If you have diversified revenue streams, you know Shopify, or your physical…your website, Amazon…different Amazon countries, Jet, Walmart, Daily Deal sites that’s diversified revenue. Diversify…diversification means less risk. Less risk means higher in that multiple range. So all of those things come into play but as I say often we can’t take an email list of 10,000 and say each email address is worth five dollars and do that math and add that to the value of the business. What it does simply is boost the value range of the business itself.
Joe: I think another way to understand this as well is that although our formula has two main parts the trailing twelve months seller’s discretionary earnings in one part and in multiple being the other part, that doesn’t mean that is…we’re looking at two things. As we’re going to go into both sides of this the multiple and the trailing twelve months are summations of bigger calculations. So when we could get to the SDE, when we’re calculating that seller’s discretionary earnings, we’re going to go over that in this podcast episode, there’s a lot involved in calculating seller’s discretionary earnings just as there’s a lot that goes into understanding what makes its multiples. These things kind of summarize the business and all of those intangibles as well. And I think a lot of people that do know this formula they focus a lot on the multiple. But I love the fact that what we’re going to do here is we’re going to unpack this seller’s discretionary earnings number and see what goes into building that. Because this is actually an area where there is a lot of opportunity for optimization [inaudible 00:12:44.4]. And once you understand this aspect of it and you plan in advance sale of your business you’re never to sell but someday you may wake up and want to move on, you understand the value you’re going to have a much more valuable business down the road. And you know I think we were at a presentation together where someone got up and said adds are the most valuable asset that you own as your business and if you don’t take care of it and you don’t understand it’s value you not really maximizing it; so really important. You know the key point here is Mark the trailing 12 months. It’s not the trailing three, trailing six times two or anything like that; the trailing 12 always takes into account the seasonality of the business and we do every…a year over year comparison when working on that multiple valuation as well.
Mark: Yeah and just one last [inaudible 00:13:32.3] on this, this is one formula that is used. It’s used in this industry for online businesses which is why we use it. It is not the only way to estimate the value of a business but what I would tell anybody out there that wants to look at different valuation approaches they all essentially do the same thing. Some do it more complex than others and at the end of the day, these are predictive formulas right? I’m trying to predict what’s base trying to pay. So anyways on with the next line, I took us back a little bit but I did want to get in to that a little bit. So add backs-
Joe: Keep doing it I do this every day and it’s simple language to me now but it is not simple, it’s pretty complex.
Mark: Right okay so let’s get into the seller’s discretionary earnings if I’m going to Quick Books because everybody I know that’s listening is using Quick Books or Xero or a professional accounting software right? Everybody’s using that I’m sure nobody’s using Excel. Where can I go in Quick Books to calculate or see what my seller’s discretionary earnings are?
Joe: You can’t.
Mark: That is not in Quick Books?
Mark: What is that, what is seller’s discretionary earnings?
Joe: It’s your net income what you get out of Quick Books or Xero plus the add backs. That’s what you call seller’s discretionary earnings. So the big question is what’s an add back? And this is why it took 45 minutes in the Q and A session that I did. So when you get to add backs and I’ll go to the next slide here this is a lot of information but really an add back is something that is a personal benefit to the owner of the company or a one-time expense. Now there are always exceptions to the rule and you always want to use math and logic. But an example is owner payroll, if someone takes a payroll of 128,000 dollars to maximize their social security, that’s an owner benefit and if your business is doing net income of 500,000 dollars, you add back 128 to that so now your discretionary earnings should be 628. Simple round numbers if you’re doing 50 in net income and you take salary of 50 you’re discretionary earnings becomes 100,000. And so if your multiple is 3X on the net income it’s only 50, on discretionary earnings it’s 300,000 big difference.
Mark: Right. So why are we adding back these expenses? Because basically what you’re doing is you’re going through, you’re taking a look at a company’s income statement or profit and loss statement and that’s something that you can generate in Quick Books or Xero or any professional accounting software. And you’re going through those expenses and you’re looking at some and you’re saying okay we’re going to add…and right now this is acting as a subtracting number to the revenue and that’s how it would get to net income. But you’re saying we’re going to actually add that expense back so effectively take it out. Why are we taking out these expenses?
Joe: They’re personal in nature and they’re personal benefit but you need to in your terminology taking it out you have to go with full disclosure to the buyers. They want to see every cent and so you don’t go into the Quick Books accounting, you delete these personal expenses. You leave them there yet you run the report you export it to Excel and then below that net income you create an add back schedule and you go up to…okay this one’s personal mail and entertainment travel or what you did a website redesign you spent 10,000 dollars three months ago. That’s a one-time expense, for the most part, we could add that back. And you had an employee that did outside sales and she tried, she was only around for three months it was a 15,000 dollars expense she produced zero outside sales commissions is that an add back? We could talk about in some cases it is. But there’s a lot of that today goes deep deep deep in the conversations with the owner of the business in order to get to the most important number which is a seller’s discretionary earnings.
Mark: All right very good. So when we’re doing these add backs what we’re doing is we’re taking out these expenses because we want to present it to buyers and show them what the business operates from a standard starting point. So we call these discretionary expenses and we call them discretionary expenses because their expenses that the owner is spending at their discretion could be circular about it. So how do you go about or I’m going to hand back over to you, what’s the next step for going through and explaining and understanding these add backs?
Joe: Let’s just give some example, some things that people brought up and I just pop something up on the screen you know question. Can I go to the gym every day? You go to the gym pretty often right? You try to get out and you might run it after your business is that a personal benefit you tell me?
Joe: Absolutely. So if you spend 50 dollars a month for the gym that’s an add back, it’s 300 dollars a year. That’s a thousand dollars added to the value of your business if your multiple is over three times. Your car, your meals, and your entertainment; a big one that you and I and the entire team talked about recently was as an entrepreneur you may travel to different events. You may go to the Prosper Show that we were out in March. You may go to arket a conference. You may go to Seller Con, whatever the case might be. Can you write those things off as an add back? And we collectively said yes. Because it’s a personal choice of the owner, in most cases you can learn those things online but you’re going for the camaraderie and it’s helping with your business in some ways but it’s not a required expense that carries forward to the new owner. And that’s the most important thing; it’s not an expense that carries forward to a new owner.
Mark: Let’s talk about that trade show example because I think that’s a really good example where we can get in and show how understanding what gets added back and what doesn’t get added back and be somewhat nuance. So let’s take two different scenarios and start with…well we’ll start with Rhodium we talked about them a bit and we like the guys in Rhodium quite a bit, it’s a good community. I would go to that event just for the camaraderie and the networking alone without necessarily have any business…there’s always a business interest with what we do but my main reason would be to go there for the camaraderie. Looking at Quiet Light Brokerage would that be considered an add back yes or no? Probably because we’re not necessarily selling our services at that point but if we display a pub con, if we get a booth display there, we’re making out to contacts would you consider that an add back?
Joe: Well let me tell you, let me correct you if you will on Rhodium. When we go to Rhodium and we are sponsoring the event, so it’s an expense to us, we stay in hotels, we have meals, we have entertainment, and we produce revenue from it because we build relationships with those people who then come to us to list the business for sale; and that produces revenue. So when you’ve got an expense that produces revenue it’s not an add back; simple as that. But an example of someone going to Rhodium…a real example, someone went to Rhodium recently and her husband decided to go as well, didn’t go to the events but was there and then they stayed an extra week and called that their honeymoon. Went on a helicopter ride that…all sorts of different things and it was a complete business expense and write off. Absolutely a write off, she can’t tie a revenue to that expense. So it’s an add back. There’s always math and logic with these, sometimes the buyers are not going to see it the same exact way that the seller or the broker will see it but we don’t push them. It’s got to be crystal clear because and full disclosure because once you’re under [inaudible 00:21:01.9] we don’t want any surprises. An example that is not an add back that someone brought up they said well I’m using an ad agency to do all my Facebook advertising and I pay them 15% and I spend [inaudible 00:21:14.4] a thousand dollars a month. That’s 150 dollars a month expense. I’d like to add that back because my logic is if the new owner has those…that experience that doesn’t need that ad agency then they’re not going to have the expense so it doesn’t carry forward right? Well, no it’s an expense that that ad agency spends money, it produces revenue, you can’t…it’s a big leap of math and logic. We don’t know if that particular buyer has that experience or not. If they do, good for them it’s a savings on their part but we can’t add it back assuming everybody has that experience. Makes sense?
Mark: Yeah absolutely. I think there’s a common sense factor here and that is what we want to do is we want to look at the expenses that have been used for the normal operations of the business, so expenses that’s been used for normal operations they stay. The elements that are outside of normal operations of the business those are the ones that are typically going to be added back, so personal benefits, those one-time expenses that’ll be outside of normal operations because it’s…it is part of normal operations but it’s such a rare occurrence. We want to show buyers what’s their expected ROI from this business if they were to acquire it. And so you can’t…you have to have a common starting around and that’s where you end up getting into the add backs and taking out those discretionary expenses.
Joe: Yeah. Let’s talk about one more sort of not black and white example just to talk about what you said which is common sense. So I listed a business last fall and the owner of the business really literally worked five hours a week. He had a full time person doing inventory planning things of that nature customer service…doing inventory planning and design and then he had someone that he had do customer service. That someone that he had do customer service was his brother and he paid him 30 dollars an hour for customer service work. The customer service work involved canned responses and canned responses and email canned responses in a pop up chat. He was grossly overpaid doing that kind of work, 30 dollars an hour. My advice at the time and you laughed at me and called me a Scrooge at one point [inaudible 00:23:24.5] was fire your brother. Okay, you’re paying him way too much. I think the total amount that he might have been paying him was roughly 30,000 dollars a year. When in reality he was paying him too much money was paying him for hours that he didn’t really work. So he should have fired his brother, hired somebody with half the cost, it made up the difference of 15,000. Let six months pass and he would have…his business when it was listed at 3 ½, so it would have 3 ½ times 15,000 dollars which would have been added to list price. He wasn’t willing to be a Scrooge because that was just before the holidays. He didn’t fire his brother. So we went with math and logic and we presented an adjustment in the add backs accounting for his brother going away.
Joe: It wasn’t ideal, it was a little gray but the math and the logic made sense and it worked. We had multiple offers under LOI closed with no issues with that add back mostly because it was right there in black and white and detail that talked about prior to the LOI.
Mark: Right. So it does work the other way as well too. I’ve actually had the opposite scenario where somebody had a bunch of friends and family helping out in their business and they were grossly underpaid because they were doing favors. And he was like the Uncle Vido or someone like that was doing the books for almost no money whatsoever. And in that case would go the other direction and we would actually inject a cost into that P and L that will basically say hey they’re here in a sweet heart rate that’s not going to continue we need to see what this role is important but necessary and here’s a pretty reasonable market rate for math and logic once again.
Joe: Yeah, it’s math and logic in there as well. Okay, I have a look at our time here Mark and where we are but a really really important thing for physical product owners is in the valuation of the business is the thing that put me to sleep in college. Literally, I fell asleep in the classroom and the new students came in and I was asleep in a classroom. It’s accounting. Okay if you’re driving pop a couple of no doze for this part but it is so vastly critical and this is critical for buyers and sellers. For buyers listen to this closely because if you find a broker that lists something that is growing like crazy, physical products business and they don’t do accrual accounting or flipped it to accrual, you’re getting that business at a discount because it should be accrual. When it’s accrual the business is…it’s the right way to do it first of all but the discretionary earnings is higher and the business is more valuable.
Mark: Hold on accrual? What are you talking about here…we’re just doing something excel at this point. So what is accrual and why is it so important?
Joe: You’re selling a widget, so let’s say you’re selling a widget for 10 dollars and your landed cost of goods sold on that widget is two dollars, 20% landed at your 3PL at your Amazon FDA. That’s a cost of goods sold of 20% that…that’s accrual so that when you sell that widget in the month of June that cost for that widget is applied to that month of June, so it’s 20%. So your cost of goods sold…landed cost of goods sold shouldn’t be roughly the same every month, month in and month out when it’s accrual. If it’s cash you’re going to see that 20% go to 60%, 102% down to zero back up again to be all over and what it’s going to look like on the bottom line discretionary earnings is that your earnings are all over the place; up and down, up and down and it’s uncomfortable for buyers. The way that they look at these things and the way that we train them to look at these things is discretionary earnings and then have some working capital for inventory. When you purchase inventory moving up to 4th quarter, if you are cash basis and you’re wrapping up inventory and normally you’ve got 50,000 dollars’ worth of inventory but all of a sudden your stroking checks and you’ve got cash out of the 150,000 dollars that depresses your net income and your discretionary earnings and the value of your business if it’s presented on a cash basis accounting. Does that make a little bit of more sense and not put you to sleep?
Mark: Yeah, that does make more sense and what I would…the way I’ve explained it to some people as well is that when you move to accrual basis accounting it’s kind of like going from a two dimensional picture to a three dimensional picture because it looks at your business and where its value is in all places. So instead of just taking cash out when as you said your 4th quarter you’re stroking checks because you’ve got to stock up that inventory you’re expecting a busy Christmas season so you’re writing all sorts of checks out. Instead of saying okay I’ve just lost that much value of business, no you haven’t lost much value you’re just taking cash and converted it over to inventory. So accrual says hey you still have value in your business because you have all those inventory, you just exchanged cash for inventory. And then when you sell that product now you recognize the expense of that individual item.
Joe: That’s the key when you sell that product that’s when you recognize the expense. And a good bookkeeper can set it up for you. And trust me if you spend a little bit of money a couple hundred, 300, 400 dollars a month on a good book keeper you will make that back multiple times over in the sale of your business because buyers will have more confidence. Brokers will be able to do a better valuation with less complexities and you won’t pull your hair out during the valuation process. And I’ve seen people do that it’s really-really hard to go back and do it. We do it more often than not we do it right Mark? We have to go back and flip it from cash to accrual then and I want to show you how to do that. So right now up on the screen, I’ve got a sample profit and loss station, a sample statement. Net income you can see there we’re going to call it 425,000 dollars. Again, we’ve got an add back schedule below it for those listening here is some of the add backs; we’ve got interest expense that they had a loan, legal and professional fees for a patent for example or a trademark those are one-time expenses, meals, and entertainment, office expenses you work from home but you’ve got your kids’ school supplies that you [inaudible 00:29:33.0] your business, your own payroll and I’ve got vehicle expenses here. So we take that 425,000 in net income plus the add backs on 120 and we’re not at 545,000 in change in terms of discretionary earnings. So again you just say a three time multiple we added 360,000 in value to this business just for the add backs. But when you look at this gray line in the cost of goods sold the cost of goods sold as a percentage of total income goes as high as 97% and as low as 5%. It’s all over the place. In the next screen, I’m going to flip it down so we know that that’s cash because it’s all over the place so here we flipped it from cash to accrual.
Mark: So this is the same company?
Joe: The same company this is the same exact P and L but within the Excel spreadsheet there was exported from Quick Books or Xero or in some cases produced, we’ve flipped the cash to accrual on the total cost of goods sold line only. We don’t change those numbers in the cost of goods sold expenses the only thing that’s changed is that total cost of goods sold line. You see sometimes those total doesn’t add up to the individual things it’s because we flipped it to accrual and we work with a formula on that. So there’s more than one way to do almost anything but we work with the seller on calculating new accrual and we’ll go into that in a minute but the key difference is when you look at this we went from cash to we were at 425,000 in net income right? Now we’ve flipped to accrual you look at that net income line that’s jumped from 425 to 485,000 so we’ve added 60,000 dollars in discretionary earnings just by flipping it to accrual. Let me repeat that for those that are almost asleep because we’re talking about accounting. By not producing any more revenue, by not hustling any harder, by not renegotiating cost of goods, by not doing anything other than good accounting we’ve increased the net income from 425 to 485. By you know proper accounting.
Mark: [inaudible 00:31:45.6] the question is this dishonest in any way?
Joe: No. It’s the absolute right way to do it. It’s standard acceptable accounting principles. The other way is the ready fire aim approach that unfortunately most of us take, me included because I didn’t know any about Quick Books or accounting, I fell asleep in class, I never had a bookkeeper. This is actually the right way to do it.
Mark: All right so that [inaudible 00:32:09.8] both cash and accrual are acceptable ways of filing your taxes and doing books. That gap does recognize both, however, accrual for a product space business is going to be more accurate and more thorough and so what you’re saying is that the cash basis actually undervalues the business when you record your books in cash basis.
Joe: If the business is growing rapidly absolutely because they’re taking almost every expendable dollar that they have and putting it back in inventory. So an example is you know you and I talk about this valuation a lot, I had a client that went to every other brokerage firm. They really needed to sell their business because they had a house under contract contingent upon sale of their business. It was for an income they lived in New Zealand they had an Amazon US Business. They had to sell the business [inaudible 00:32:58.7] tough situation to be and a foolish situation to be in. They went to…got different valuations and every broker is trying to push that multiple high to help them achieve their goals. Too high for that 18-month old business, [inaudible 00:33:13.4] we did the proper accounting flipped, we did it in accrual. I was able to push that multiples down and other brokers like 3 ½ it was never going to happen. We were able to push it down to about 2.7 yet the value of their business was a couple hundred thousand dollars higher. So we had a higher value and a lower multiple more attractive to the seller more attractive to buyer. We had a buyer that was really good at accounting, really good entrepreneur, fully understood it, bought it, went through to do diligence, really happy. Both buyer and seller happy. So there’s just huge value.
Mark: This is actually really good I guess pro tip for people buying as well. If you come across an opportunity that’s now with Quiet Light because we are going to almost always be pushing our clients simply in order to accrual in pretty much every circumstance for an e-commerce business. But if you come across an opportunity as a buyer and you see cash based books for an e-commerce business, take a look at the trend of the business. If that business is growing as you point out Joe the net…then the cash basis accounting is going to undervalue the business. On the other hand, though if that business is shrinking and they are not adding new inventory, they are going to have inflated or apparently inflated margins because they’ve stopped by an inventory, they’ve stopped recording expenses and you could actually end up over paying for a business if it’s on the decline. So that cash basis accounting just for a product based business it’s unreliable because of the fact that it doesn’t take into account when the expense of the item when it’s sold and so you really have to pay attention to the other aspects of the business such as this trend.
Joe: Absolutely and you know cash basis accounting is okay for SaaS business and things that don’t have accounts receivable…things of that nature. But for a physical products business accrual is the way to go. Buyers will be aware if it’s cash especially as Mark said if it’s declining buyers get excited. And it’s growing unlike crazy as cash basis you buy it hold it for a year or two and then you do accrual based accounting and your value is instantly higher. So in this example again to move things along we’ve added 60,000 in discretionary earnings if by example we were at a three time multiple that’s 120,000 dollars…I’m sorry 180,000 dollars added to the value of the business by not selling a single widget more. Really [inaudible 00:35:34.3] so how do you calculate accrual? It’s really complicated, to be honest with you and you’ve got to have a good history and records to do it. Again, start with a good goalkeeper but the formula is simple beginning inventory plus purchases minus ending inventory that equals your cost of goods sold. And this should all be landed and this is ideally on a monthly basis. Now you can do it, right? If you haven’t done it yet you can’t do it. So what you got to do is go back in history and figure out what your cost of goods sold are with different formulations and calculations and it’s different for each client that I work with. Absolutely doable I get two listings in the last two months where we had to do that and couldn’t do this. I’ll be honest with you most of the times we can’t get to this. It’s ideal if we can but more often than not we have to go with another method which is take all of those purchases take all of the shipping cost average out the shipping cost times the number of units that your shipping…it’s complicated and I can’t tell you exactly how it is because every situation is different. But that’s the formula. The end result again when you put to accrual is a higher value. Again going back quick review before we put too many people to sleep with this your most valuable asset is more than likely your business. You should know what the value is within a certain range 10% I hope and then the question is okay I know how to calculate seller’s discretionary earnings, the final thing is what kind of multiple range do I put on it? And what I’ve got here up on the screen is for physical products businesses and I’ll talk about content businesses and SaaS businesses and so on so forth as well. So a larger business is more valuable and in what ways Mark?
Mark: Large businesses are more valuable. And at today’s podcast episode that actually launched today was on that very topic is buying big better than buying small, I’ll go back and [inaudible 00:37:27.9] that one fun episode. Larger businesses are more valuable because they are more stable. You have more resources available to hire out work or to reinvest in the business. So generally speaking businesses that have higher earnings and higher revenues end up getting a multiple boost just because they are more stable and have more room for or investing in and changing the format of the business.
Joe: Right and the other thing is odds are we’ve been around a little bit longer too or they have multiple streams of revenue balanced less…essentially they are less risky therefore they’re worth more. So in the examples, I’ve got up on the screen and we’ll talk about [inaudible 00:38:10.6] for listeners. If you have seller’s discretionary earnings on a physical products business of less than 700,000 you’re going to be in the 2 and I’m going to do a broad range 2 ½ to 3 ½ multiple range. So if your business is 100,000 dollars in discretionary earnings, the value big range 250 to 350 plus the landed cost of good saleable inventory on hand at the time of closing. Again as Mark said at the beginning we take all of those other factors, how many streams of revenue do you have. do you have any patents, how do you launch new products, do you have a big social media following that proves that your margins are done without discounts or advertising. All of those things come into play and could push a multiple higher or push it lower even below this 2 ½ times in the even when we do that client interview we do the valuation process, let’s say that you have a patent infringement issue and it’s still something that’s scary and hanging out there. That might push the value down a little bit. Or if you’re trends are going down that’s definitely going to push the value down a little bit. So again, less than 700 in discretionary earnings 2 ½ to 3 times plus the landed cost of good saleable inventory on hand at the time of closing. When you get that bigger more valuable business with discretionary earnings that are north of 700 and again these are great numbers by the way again nothing here is in black and white but the value is going to be higher. Because it’s more established, less risk that somebody is going to pay more because their money safer. That value range is going to jump instead of 2 ½ to 3 ½ you’re going to go from 3 ½ to 4 ½ sometimes possibly higher.
Mark: And if anyone is listening to this a few years down the road and have dug back in the Quiet Light Podcast archives and are now listening up. Multiples do change over the years as well. So this is where the market is at today and always check with us to see where multiples are if you’re listening to this at a different time.
Joe: Got it. SAS businesses. SAS businesses is in the last 12 months good ones that are trending well that have a reasonable [inaudible 00:40:14.7] and have a good handle on the metrics, I’m going to talk about that in the next episode, you’re in the four to five time range. Content sites again and much of the same dollar ranges here. Content sites probably 2 ½ to 3 ½ times unless you’re much larger. I’ve got one with multiple offers that’s between four and five times because of the size of it and because of the growth. It’s discretionary earnings are well north of a million dollars. Affiliate sites, same thing. The real separator here is I think the SaaS business because it’s generally B2B recruiting revenue and the value is a generally higher at least felt…buyers feel as though they’re worth more. Buyers are usually right no matter what Mark and I and the seller thinks. Buyers [inaudible 00:41:03.1].
Mark: And we’re going to be doing another episode of talking about multiples and how do you determine the multiple of your business because that’s a pretty complex valuation as well. Where there’s literally dozens of factors I know I wrote a guide…I think it’s on the website right now called The Ultimate Guide to Website Value. I wrote it three years ago. I think maybe four people have read the whole thing because it’s long. It was around 30,000 words of all the different things that can really impact the value of a website. I should probably go back and update that because I’m sure there’s some things in there that needed to be updated now, a few years later. But there are a lot of things that can influence that multiple up or down.
Joe: Let’s leave the listeners with this Mark and it’s something that we talked about a little bit. If you look at your own values and your own assets, anybody that’s listening and you own a business, think about the different things that you own: your bank account, your retirement portfolio, your house, your car. Do you know what the values of those are plus or minus 10%? You probably do but do you know the value of your business plus or minus 10%? You probably don’t. Hopefully, this podcast will help a great deal. But even with all the information we’ve shared you really can’t figure it out until you do a proper add back schedule and do all those details. I’ve had calls, we’ve had lengthy calls with buyers, we’ve gone through it all and if I…yeah on my values about 850 and then we get to P and L it turns out their value is at 1.2, really important to get the details down. Get a handle on it even if you don’t plan to sell the business either ever or six or 12 or 18 months down the road.
Mark: Very good well if you made it to the end of the episode here congratulations and we really appreciate you while listening in. I’d be interested in hearing feedback what do you think about episodes like this where it’s Joe and I or maybe we’d bring Jason on or Chuck on again and we delve deep into some of the things that we do on a day to day basis. Are these helpful for you? Do you like them? Did I put you to sleep? Do they…are they things that you would want us to do more of? Let me know send me an email [email protected] if you absolutely hate it then email Joe at [email protected] So anything left to…anything more to say here?
Joe: No, that’s it. It’s a lot of information it’s a bit overwhelming and just digest it. We’ll have a link to this presentation in the show notes so people can download it. You’ll get a little summary video of it as well that we can share [inaudible 00:43:32.2] can go through their own process. And then one more thing I guess yes I do have something. I have a client recently that I’ve been talking to for 18 months and you know I said: “What’s the one takeaway after all we’ve gone through?” And she said “More than anything else if I could convey and share something with people that are trying to understand the value of the business and might sell it is don’t be afraid to talk to a broker, get a valuation, figure out those things that you need to fix so that 12, 18 months down the road, the business is more valuable and you’re prepared.” That’s the key thing.
Mark: Absolutely we do have resources on the site, articles that break down how to do a seller’s discretionary earnings calculation. We’ll link to those in the podcast show notes. So if you want to get deeper and couldn’t follow along everything in this episode there are some articles that you can refer to which will be easy to follow as well. so thanks for listening and we will be talking again in a week.
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