In this podcast episode, Carl Allen provides a detailed explanation of how to value and structure a business deal. He begins by discussing the importance of understanding the true EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) through a process called recasting. This involves adjusting for the real profits of the business once the seller is no longer involved, taking into account factors like owner salary and other expenses that may change after the acquisition.

Carl then explains how to calculate the adjusted EBITDA by adding or subtracting certain costs, such as the replacement of the owner with a general manager or introducing rent for a building that wasn’t previously reflected in the business’s financials. He uses a real example of a business generating $2 million in revenue with a 20% margin, adjusting the EBITDA to $450,000 after these considerations. A market multiple of three times EBITDA is applied, giving an enterprise value of $1.35 million.

Next, Carl outlines the difference between enterprise value and equity value, emphasizing that enterprise value reflects the asking price before liabilities or surplus cash are factored in. In his example, after accounting for surplus cash and liabilities, the total equity value of the business comes to $1 million. He notes that understanding this distinction is essential for structuring a fair and accurate deal.

Carl also discusses the components of structuring a deal, including closing payments, seller notes, and the potential use of an earn-out structure. In his example, he proposes paying $200,000 at closing, funded by the business’s surplus cash, and then structuring the remaining $800,000 over four years with a seller note at 10% interest, which would comfortably be covered by the business’s cash flow.

He concludes by reinforcing the importance of cash flow and how it can support the deal’s structure while ensuring debt service coverage. Carl’s practical insights offer a comprehensive guide to valuing and structuring a business acquisition, providing listeners with actionable advice to consider when making a deal.

Full Transcript:

Before we do that calculation, we’ve got to figure out is that the true EBITDA number. So we’ve actually got to go through something called a recasting process.

Hey, guys. Carl Allen. Wanna do a little quick video for you today about valuing and structuring a business. So I wanna give you a really kind of simple walk through about how this actually works.

So let’s imagine you’ve gone and you found a business, and it’s doing two million dollars per year in revenue. Okay. So that’s really, really good. And then let’s assume the business has got a twenty percent operating profit margin.

So twenty percent margin would be four hundred thousand dollars per year in we’re gonna use the term EBITDA.

So that’s the profit measure we’re using earnings before interest tax, depreciation and amortization of goodwill. So four hundred thousand dollars is the EBITDA. Now we know that businesses are worth a multiple of that EBITDA. Every kind of business sector has a range, but then it depends on the quality of the business within that range that determines whether it’s attractive to buy, it’s transferable, and the business could be worth zero up to, you know, whatever the multiple is, three, four, five, even a six times multiple if you’re in the e com space or the SaaS space.

On an average, the multiples between two and a half and three was actually about two point eight was the average small business multiple for all businesses, sub ten million dollars in revenues in twenty twenty two. So this is an engineering business. This is the example. This is a deal I’m actually looking at right now.

The numbers are a little bit different, just for mathematical ease. So, normally, you’d be looking at around a two and a half to three times multiple for this business. Now before we do that calculation, we’ve got to figure out, is that the true EBITDA number? So we’ve actually got to go through something called a recasting process.

Now on Wall Street, where I did most of my earlier deal making work back in the nineties and the early two thousands, With the term we use for that is called pro form a. And what that means is we need to understand that once the sellers out the business, what are the real profits going to be? So for example, in that number, is the owner taking a salary? If not, you’ve got to put a GM in the business to run it for you.

You’re gonna be reducing that number before we apply the multiple.

If the sellers take in, you know, a million dollars a year out, of that business in salary and that’s reflected in the EBITDA, yet it’s only going to cost you one hundred thousand dollars a year for somebody to come in and run that business for you, then that would be an add back. So an add back to EBITDA, let’s call that AB, an add back to EBITDA is when we’re going to increase the profitability before we apply the multiple because the owner has been taking things out of the business, that are not going to happen once we acquire it. And then where we’re going to be reducing the EBITDA because it’s gonna have additional costs for us to run that business going forward, like the GM, for example, that’s called a take back.

So an add back is when the profit’s gonna go up. A take back is when the profit’s gonna go down. So a great example of an add back would be, the the owner, is let’s say the owner’s spending two hundred thousand dollars a year on his own compensation, And that’s before the EBITDA line, and then obviously, he’s gonna take a distribution as the owner of that business. So he’s taking two hundred thousand dollars out of his salary, but it’s only gonna cost us a hundred thousand dollars to replace him with a general manager.

So in this example, we can have a justified one hundred thousand dollar add back. K? A good example of a take back would be, let’s say the business owner works inside of the building and he owns the building. Right?

And the building is sat on the balance sheet of the business, but he’s not selling you the building as part of the deal. You’re just buying the business. You’re not buying the real estate. The seller wants to keep the real estate because real estate always tip goes up in value.

He wants to keep the real estate, and then he wants to charge you a rental fee. You need to stay in that building. But in the EBITDA calculation, there’s no rent. So we need to make a rent adjustment, and that is a take back.

Because when you start paying that rent after you’ve bought the business, your profitability is gonna go down, and we need to reflect that. So let’s say the take back, let’s say the rent for this building again, let’s say it was fifty thousand dollars a year.

In terms of the calculation, we’re going to add a hundred thousand dollars as an add back, and then we’re gonna take away fifty thousand dollars as a take. So now we know that our valuation in terms of an EBITDA is four hundred and fifty thousand dollars. Four hundred plus a hundred, which is five hundred less than fifty thousand dollars. So four hundred and fifty thousand dollars is the EBITDA that we’re gonna be using as part of the calculation. If you’re going through a business broker for the deals that you’re looking at, the broker has typically done all of this work, for you, and you’ll see something called an adjusted EBITDA.

And what’s kind of interesting when you’re looking at deals is you get the tax returns, which are what I call the tax numbers, and then you get the brokers numbers, which are the real numbers. And then you’ve got to kind of go through and you’ve got to adjust and negotiate those numbers. So four hundred and fifty thousand dollars is the, is the EBITDA here. So that’s what we’re gonna call the adjusted EBITDA. And let’s say we’re feeling very generous and we’re gonna apply a three times multiple market multiple to value this business. So three times, four fifty is one million three hundred and fifty thousand dollars.

Now that we call enterprise value, EV. That’s the value of the business.

It’s not the value of the stock or the equity in the business. We need to do some more calculation. So when you think about enterprise value of a business, that’s like the asking price when you go and you buy a house. So let’s say you go out there and you’re looking to buy a house and it’s half a million dollars, and Realta got a nice kind of one pager.

Says, hey. This house, it’s, in the middle of Albany, New York. Probably cost you more than half a million dollars in Albany, but five hundred thousand dollars is the asking price. So that’s like the enterprise value.

The equity value of the house is the value less the debt that the owner has on that house. And it’s the same in a business. So there are three things that we need to adjust in enterprise value to get equity value. The first one is real estate.

So that’s the value of the business. If we were buying the real estate as well, we’d be paying for that separately. So if the real estate was worth three hundred thousand dollars and we were buying that alongside the business, we’d be paying one point six five million. So one point three five for the business, dollars three hundred thousand for the real estate.

So if you’ve got real estate in the deal, that’s always a plus. In our example, we don’t. So that’s a zero. The next thing that we have in a deal is surplus cash.

Now this is very, very common in the UK, not so common in the US, especially if you’re buying an s corp or an LLC. And the reason for that is s corps and LLC in America have a flow through tax policy. So it’s very common for a business owner to distribute out all of the earnings at the end of the year and then maybe learn a little bit of that back just to give the business a little bit of working capital trade going forward. So normally, when I’m valuing a business, I wanna see at least, one month’s worth of revenue or roughly about ten percent of the revenue, in cash.

So in that business, I’d want at least two hundred thousand dollars of cash in the business for me to kind of trade it and play with it as the new owner. But let’s say that business actually had four hundred thousand dollars of cash inside of it. Right? So that extra two hundred thousand dollars, we’re gonna have to pay for as part of the deal.

So that’s gonna be an addition of two hundred thousand dollars to surplus cap. Okay. So that’s a positive as well. And then the negative would be what liabilities are we gonna be inheriting when we take the business on.

Now sometimes you can buy a business called debt free cash free. So the seller’s gonna take all the cash less that two hundred thousand dollars that you need to run the business. But then they’re gonna take the closing payment, and then they’re gonna discharge, they’re gonna pay off all of those liabilities that you’re gonna inherit as the as the new owner so that you get the business effectively debt free. But the problem with that is you’re then gonna have to go out and raise capital to make that closing payment.

If there’s liabilities already in the business, it makes no difference to what the seller’s gonna get. You’re better off buying the business and inheriting the liabilities that are already inside of it. So let’s assume that’s what we’re doing in this case, and this business has, five hundred and fifty thousand dollars of liabilities.

So that could be tax notes due. It could be a bank loan. It could be, the money that’s outstanding on, like, higher purchase equipment.

Liabilities, these are noncurrent liabilities. So it’s not AP, although I do just for AP in a, in a in a b to c where the company is selling directly to, to consumers. We’ll get into that in another video.

But I’m gonna be inheriting five hundred and fifty thousand dollars of debt when I take this business off. If I all that up, I’ve got one point three five million, then I’ve got two hundred thousand pounds of surplus cash, no real estate, and I’ve got five hundred and fifty thousand dollars of liabilities. So my equity value, what I’m actually paying to buy the stock in the company, buy the equity in the company is a million dollars.

So a million dollars is my valuation for one hundred percent of the equity in the business. Right. So once I figured that out, now I’ve got to decide what’s my deal structure. Okay. So remember, when you’re buying a business, there’s three components.

You’ve got the liabilities that you’re inheriting, which in our case, five hundred and fifty k.

You’ve got the closing payment, and then you’ve got the seller note. And in some cases, you can also have something called an earn out, which if you have a valuation for the business lower than what the seller’s expecting because they’ve got long term growth and all these crazy things that might happen in the future, we put that into something called an earn out. And I’ll do a separate video on that a little bit later. But for now, let’s do it in these three ways.

So let’s say we’ve got a million dollars left to cover through the closing payment and the seller note. Now it’s in your interest, obviously, to have as little of the deal inside of a closing payment. If you’re gonna do an annuity deal structure, the closing payment would be zero or just a little bit of surplus cash that’s gonna be in the business. Now remember, we already have two hundred thousand dollars of surplus cash in the business that we’re buying.

It’s cash that we don’t need. It’s included in the valuation.

So at the very least, we can give the seller two hundred thousand dollars at close because that cash is in the business. We don’t need to go out and raise it. We don’t need to put our own money in. We don’t need to partner with an investor.

We don’t need to go to the bank. We don’t need to go anywhere. That money is already in the bank, so we can offer that to the seller at closing. So the rest is eight hundred thousand dollars So total deal as a summary, we’ve got five hundred and fifty thousand dollars of the liabilities that we’re going to inherit.

And then the million dollars that we’re paying for the equity in the business, we’ve got a two hundred thousand dollar closing payment. That’s what the seller’s gonna get at the closing table. And the rest of it is gonna be an eight hundred thousand dollar seller note. Now the beauty with that is because the business is generating four hundred and fifty thousand dollars of adjusted EBITDA, we have a lot of cash flow that we can use to do that deal.

So what I would do, my opening offer on this business will be to do that over four years, which is two hundred thousand dollars per year. And let’s say the guy wants a ten percent interest coupon, as well on that.

So ten percent, let’s say we’re gonna be paying two hundred and twenty thousand dollars per year in seller notes. We’re already generating four hundred and fifty thousand dollars of cash flow.

If we’re paying out two hundred and twenty thousand dollars, we’ve got a debt service cover ratio of just over two times, about two point one x. Right? Anything north of one point five, you’re golden. And that’s before you even grow the business.

You’re buying a business in your lane, and you can add a lot of value to the business. You might be able to take that to three million dollars in a few years or even four or five million dollars in a few years. When you do that, these payments are not going to change. It’s like you’re buying a house, making mortgage payments to the bank.

If you fix that house up or something happens where the value explodes for that real estate, the bank’s not going to call you up and say, hey, I need more money now because your your house has gone up. No. Not at all. That’s where an earn out would do that, but we’ll talk about earn outs in another video.

That’s separate. I don’t want to confuse you. But that is a really, really good deal. So let’s summarize.

What have we done in here? We’ve looked at a business, dollars two million in revenue, twenty percent margin, cranking out four hundred thousand dollars in EBITDA. So that was step one. And then step two is you said, well, okay, What are the real numbers?

What’s the EBITDA gonna be when the owner leaves and we become the new owner? So there’s a hundred thousand dollar add back, because the owner’s taken out too much salary. And then there’s a fifty thousand dollar take back because we’re gonna have to pay rent, stay within the building, the real estate that the seller owns. So that gives us an adjusted EBITDA, a pro form a EBITDA, a recasted EBITDA of four hundred and fifty thousand dollars And then a sensible multiple for this type of business in this type of market, it’s a three x market multiple.

So three times four fifty gives us a one point three five million dollar enterprise value. And then we’re making those three adjustments. Adjustment one, if there’s real estate, there isn’t in this deal. Adjustment two is any surplus cash.

We have two hundred thousand dollars of surplus cash, so we’re adding that. And then the seller wants us to inherit the five hundred and fifty thousand dollars of noncurrent liabilities that are set on the balance sheet. So we’re gonna inherit those liabilities as well.

So we add all that up, one point three five plus two hundred less five fifty, the million bucks to buy a hundred percent equity in this business. If the seller said, well, hey.

I like your growth story. I’ll just sell you eighty percent and let me keep you the twenty percent in, then what would you be paying? Eight hundred thousand dollars So that’s the value of the stock. You’re buying all of the stock.

It’d be a million bucks. You’re only buying eighty percent of the stock. The seller wants to carry a little bit back. You’ll be paying eight hundred thousand dollars But the beauty of this deal is there’s tons and tons of cash flow that are already going through the business to comfortably make those seller payments.

And the deal that I would structure on this is, hey. We’re gonna we’re we’re gonna do the five fifty of liabilities. I’m gonna inherit those. I’m gonna pay the two hundred thousand dollars of cash at the closing table, which is cash that’s already in the business that I don’t need, and then I’m gonna put the rest on an eight hundred thousand dollar seller note, two hundred thousand dollars per year over four years plus a ten percent coupon.

So that’ll be two hundred and twenty thousand dollars per year. So that gives me a two x cover ratio. And then all I need to do, which I’ll then cover on another video, is to keep this short, is I’ll then look at those liabilities.

And those liabilities, by the way, were actually over a ten year term.

So I know as well I’ve got an extra fifty five thousand dollars per year that I need to use from this cash flow to cover those existing debts that I’ve got as well. So this is a really, really, really cool deal. So I will be making, that offer. I hope you found this useful, and I will see you soon on the next video. Until then, bye for now.

Hey, guys. I’m Carl Allen. I’m the founder of DealMaker World Society. I’ve done tens of billions of dollars of deals over the last thirty plus years.

If you’re new to my channel, definitely hit like and subscribe so you can get all of my amazing DealMaker content in real time. You’re not gonna miss any of the outstanding information that I’m gonna share with you. And if there’s a question that you’ve got, if there’s something that you want to know the answer for and you want me to speak to it, definitely hit me up in the comment section, and I will record those videos for you. And I will get them on this channel as soon as possible.

So love having you part of this YouTube community, and I can’t wait to serve you.

Until then, bye bye for now.