This is the first post in a series called “Valuing Your E-Commerce Business”. Click here to see all posts in this series.
Whether you’re thinking of selling in the next few years or just want to know where you stand in the current market, it’s important to understand how to correctly value your business. In this week’s contribution to our valuation series, Tyler explains why understanding SDE and add-backs is the first step to accurately valuing your company for a sale.
Understanding the Market
When it comes to market value, every material thing in the world is only worth what someone will pay for it. For example, you may have the world’s rarest Beanie Baby in your possession, and a handful of BuzzFeed articles claim it’s “worth” $5,000+ – but if the highest bidder on eBay will only pay you $150, it’s really worth $150.
The same principle stands with houses, cars, and to some extent, businesses. But valuing a business is much more complex than a Beanie Baby; there are many more variables at play than there are for a material valuation.
Luckily, e-commerce businesses are slightly easier to value than a brick and mortar store, since there’s no need to worry about property value, showroom rental costs, or in-store employee wages. In addition, the value associated with e-commerce businesses is homogenous enough that it’s fairly easy to compare one company to another, and that comparison is what allows for accurate appraisals.
SDE and Add-Backs
In the beginning stages of your business valuation, you’ll be looking primarily at Seller’s Discretionary Earnings (SDE) for the trailing 12 months of your business. In order to calculate your SDE, you’ll take your overhead spending for the year and add back certain expenses. These are called, appropriately, add-backs.
Add-backs are expenses that you as the business owner chose to spend capital on that another owner may choose not to. The purpose of adding back these expenses is to create more value in your 12-month gross profit. In simplified terms, you’re showing a possible buyer what profits could look like without discretionary spending in specific categories.
Before determining what to include as an add-back, you’ll need expand out your trailing 12 months of overhead to view detailed spending categories like rent, contractors, software, and owner salaries. Then, you’ll determine which categories are likely to be continuing expenses for a new owner. These are NOT add-backs, as the new owner will have to continue to spend money on them, so they will still be figured into the valuation. Categories that are almost always considered add-backs are owner salary and rent, since these will largely vary from owner to owner.
There are a lot of gray areas in this process, so it’s important to determine what’s a vital part of your business as you decide what to add back. For example, software is sometimes an add-back, since a new owner may choose not to use what the previous owner did; however, if the software in question is a backbone of the sales process (e.g. all of the seller’s inventory is handled through Skubana), that software may be considered a continued expense and not an add-back.
Similarly, if your company contracts out a VA who takes on a considerable workload at the company, that contractor’s wages would not be considered an add-back. A contractor whose wages would be added back would be a VA who is only responsible for inbox management or handles customer service.
It’s up to you to determine which expenses are intertwined with the core of your company’s day-to-day operations. The most important rule of thumb is to minimize the amount of add-back arguments you have to have with a potential buyer.
The market is what determines the true value of your business, and it does this by determining a multiple of your SDE – 2x your SDE, 4x your SDE, etc. There are certain factors that go into figuring your market multiple, such as product dominance, the complexity of your supply chain, your product margins, the company’s growth rate, and even how well your systems and processes are documented.
Businesses that are harder to sell, like those in a declining market or with lower product margins, will sometimes have a lower multiple. The market will value a weaker business with a lower multiple, and since the SDE multiple effectively determines the cash value of your business, lower multiple = less cash valuation for the sale.
For the next post in this series on valuation, we’re taking a look at how inventory impacts the value of your e-commerce business. Check back next week for more in this series!