At the end of the first bridge, a business has a number: seller's discretionary earnings, a year of one owner's earnings built from closed books, with every adjustment documented. The number answers the question an owner-operator asks first, which is what the business would pay them if they bought it and ran it themselves. What those earnings are worth is a separate question. The answer depends on who is buying, what they have to believe, and how sure anyone can be of it.
SDE is pre-tax earnings before interest, depreciation and amortization, plus one owner's full pay and benefits, plus discretionary and one-off items. For a buyer who will step into the owner's seat it is a sensible definition. It is also easy to misuse, because it looks like a measure of profit when it is really a measure of profit plus a job.
What a buyer is asked to believe
Every valuation rests on a story, and at this anchor the story is specific. The business produced one year of owner's earnings from closed books. Those earnings will be there for the next owner who steps into the seat and works it. And they are not carried by one customer, one price or the seller's own relationships.
The first bridge produced a record to test each part. That the earnings exist is shown by the closed books, the tax returns reconciled to them, the revenue history and the documented add-backs. That a new owner can take them over is shown by the owner's draw paid from profit, a year of operations funded without new capital, the gross margin by line and the compliance file. That they will persist once the seller leaves is shown by the spread of customers, repeat purchases, price rises that held, the growth record and the spare capacity. Any claim in the story with no record behind it is removed, and any number the story does not explain is not used.
What the story claims is that the business runs with a competent owner. It does not claim the business runs without one, and that is what the buyer is pricing. So the handover from seller to buyer is treated as part of the story and valued as an event in its own right, with its own probability of going badly.
Whose value
The usual standard here is fair market value: the price between a hypothetical willing buyer and willing seller, neither compelled, both informed. A broker's listing and a lender's file both assume it. Beside it sits the value to the particular buyer across the table. A buyer who can fill the owner's seat for less than the market salary, or who brings customers of their own, may pay more, but that difference belongs to the buyer and not to the business, and a seller who prices as though every buyer were that buyer will be disappointed by the others. Where the number is headed to a court, in a divorce, an estate or a dispute between owners, the law sets the standard and usually limits or forbids the discount for illiquidity, so the valuation states which standard it has assumed.
The business is valued as a going concern, and the alternative is computed too: what its tangible assets and receivables would fetch in an orderly sale, less the costs of selling them and winding down. For many businesses at this anchor the two figures are closer than their owners expect. Where the going concern is worth less than an orderly sale of its assets, the honest conclusion is that the business is worth its assets.
Where a business has more than one owner, the ownership agreement is examined at this anchor, the first one with earnings. The questions are whether a buy-sell agreement exists, what triggers it, how it sets the price and at what level of value, who chooses the appraiser and how the purchase is funded. A dispute between owners is one of the ways a business ends up valued in a hurry, and when it happens the agreement decides most of what follows.
From SDE to a cash flow
SDE is not a cash flow, and it is not a return on capital, so it cannot be discounted as it stands. It has to be converted first. A market salary for the work the owner does comes out, from a named survey for the role, sector and region, because a buyer who will not do the work will have to pay someone who does. Then the spending that keeps the assets working comes out, and the cash taxes the business pays. For a growing business, the capital and working capital that growth absorbs come out as well, so that the cash flow pays for the growth it is credited with. What is left is the cash the business produces for everyone with capital in it, and that is what gets valued.
From SDE to a cash flow
Illustrative. SDE is one owner's earnings, not a cash flow. Before it can be valued, it pays a market salary for the owner's seat, the spending that keeps the assets working, and tax. What remains is the cash flow a business with no growth produces, and capitalizing it at the cost of capital gives its earnings power value. Depreciation is set equal to the maintenance spending here, so the two cancel.
In the illustration, a business with SDE of $205,000, an owner's seat worth $120,000 at market, $10,000 of maintenance spending and a 25 percent tax rate produces $56,250 of cash a year with no growth. Capitalized at a 20 percent cost of capital, those earnings are worth about $281,000.
Brokers price businesses at this anchor as a multiple of SDE. The framework keeps the multiple and labels it as a price. Multiples from databases of comparable sales show what buyers have paid for businesses of a similar sector and size, and the factors that move them are worth knowing: the size of SDE, the share of revenue from repeat customers, how concentrated the customers are, the owner's hours and role, the age of the business, and whether the premises transfer. A multiple of SDE prices the job along with the business, which is why it suits an owner-operator and misleads anyone else. It is evidence about the market. It never decides the value of this business.
Why this buyer's required return is high
The buyer at this anchor is the least diversified buyer anywhere in the framework, with their livelihood and most of their savings riding on one business. A diversified investor can ignore the risks specific to one company, because those risks average out across a portfolio. This buyer cannot, so their required return prices all of the business's risk, including the part a portfolio would wash out. That gives the highest required return at any anchor, and so the lowest value for each dollar of cash flow.
The high rate is not then raised again for this particular business's risks, because each of those is handled somewhere else. The owner's labour is priced out of the cash flow through the market salary. Customer concentration and the seller's relationships are named scenarios with probabilities. The weakness of compiled statements and a short record shows up in how much weight the business's own earnings receive and in a wider margin of safety. The handover is a scenario of its own. Each risk is counted once, in one place, so none is subtracted twice and passed off as prudence.
Whether growth counts
Growth is valued only behind a gate, which is evidence that something stops competitors from earning away what the business earns. The test starts with the return the business makes on the capital it uses, measured on one definition that every later anchor will use: its working capital, its fixed assets at cost, and its intangibles at what it would cost to reproduce them. That return is compared with the cost of capital. Because the record at this anchor is short, a year or two, the measured return is first pulled toward the cost of capital, so that one good year cannot pass for a lasting advantage.
Does growth count?
Growth is valued only behind a gate: evidence that something stops competitors from earning away the business's returns. Check in order; the first failure means growth is valued at zero. Pricing power supports the case but never replaces it, and local size counts only alongside captive customers.
A return above the cost of capital is necessary but not enough. The business also has to show that its customers are captive, meaning they come back and leaving would cost them something. And the competitors around it have to have held their shares across every year the business has mapped them, with few entering or leaving, because a market competitors enter freely has no barrier however stable this year's shares look. Pricing power, shown by price rises that held, supports the case but never replaces it. Being the largest business in a town counts only alongside captive customers.
Many businesses at this anchor do not pass the gate. For them growth is valued at zero, and any return they currently earn above the cost of capital is assumed to fade to that cost over a few years, because without a barrier competition will take it.
Three layers
The valuation then sets three figures side by side. The first is reproduction value, what a competitor would spend to rebuild the business from nothing. That means its equipment and inventory at replacement cost, the working capital it needs to operate, and its intangibles at the cost of reproducing them. The customer list is counted at what it cost to win each customer and the trained workforce at what it costs to recruit and train them. The licences and premises go in at what it costs to secure them, the product at what it cost to develop, and the name at what it cost to make known. The second figure is earnings power value, what the current earnings are worth with no growth at all. The third is the value of growth, which is zero where the gate is not passed.
Three layers of value
Illustrative, for the same business. What a competitor would spend to rebuild it, what its current earnings are worth with no growth, and what growth adds on top. Growth adds nothing here, because the business has not shown it can earn more than its cost of capital on what it reinvests.
Value, thousands of dollars
Earnings power is only a little above the cost to rebuild, and growth adds nothing: the buyer is paying for a working set of assets, with a modest margin for having them assembled.
Show the numbers
| Layer | Value, thousands of dollars |
|---|---|
| Cost to rebuild | $240k |
| Earnings power | $281k |
| Growth | $0k |
In the illustration, the business would cost about $240,000 to rebuild, its earnings power is worth about $281,000, and growth adds nothing.
Setting earnings power beside reproduction value tells you what the buyer is paying for. Where earnings power is well above reproduction value, the business earns more than its assets would justify, and something is protecting it. Where the two are close, as they are for many businesses at this anchor, the buyer is paying for a working set of assets, with a modest premium for having them already assembled. Where earnings power falls below reproduction value, the business earns less than its assets cost to replace, and the question becomes whether it would be better sold for its assets.
Illiquidity and the final number
The buyer at this anchor buys the whole business, so the discount for illiquidity is narrow: the cost and time of selling, and nothing else. It is computed from the transaction costs, the expected time on the market and the depth of the pool of buyers who could finance a purchase of this size. The owner's death, disability or divorce are left out of the discount and treated as scenarios with their own probabilities, so each enters the valuation once.
The three approaches are then weighted by how strong the evidence behind each one is: the income approach built from the cash flow, the market approach built from comparable sales, and the asset approach built from reproduction value. On compiled statements and a short record, the comparable sales often carry better evidence than the business's own cash flow. Even so, the market approach never gets more weight than the income approach, because it estimates this business by looking at other businesses. The valuation is built before any listing price, broker's opinion or offer has been seen. Every price that arrives afterwards is reversed into what it assumes about growth, margin and the owner's salary, so that the negotiation can be about which assumptions are believable. A margin of safety is stated beside the conclusion, showing a reader how much of the value rests on forecasts and how much on what is already there.
What a listing price assumes
Illustrative, on the same business. A multiple of SDE is a price. Reverse it into the salary for the owner's seat it implies, holding the maintenance spending, the tax rate and the cost of capital where the valuation put them, and set that beside the market salary. A figure below zero means no salary could justify the price.
In the illustration, a listing at an illustrative two and a half times SDE asks $512,500 for the same business. Held to the same maintenance spending, tax rate and cost of capital, that price holds up only if the owner's seat could be filled for $58,333 a year, less than half the $120,000 the survey gives for it.
Who underwrites it
The underwriter at this anchor is an owner-operator who will run the business, usually with a lender behind them whose file asks for the same evidence. They refuse to pay for add-backs they cannot verify or for revenue tied to a customer who may leave with the seller. Being undiversified, they demand the highest return of any underwriter and pay the lowest multiple. A business sold at this anchor goes to the buyer who carries the most risk, and that is why every risk the first bridge removes shows up in the price.
What the crossing produced
The checkpoint at the end of the first bridge lists what the crossing must produce, and the next bridge inspects the same list on its first day. The list falls into families. There is a year of books closed and reconciled each month, with two years of tax returns reconciled to them, and a revenue history long enough to show a trend, with gross margin by line. There is a draw paid from operating profit with a cushion, in its lawful form, and an add-back schedule with every item sourced. There is a customer list with each customer's share, and a compliance file. There are the records that evidence growth, from repeat purchases and price rises that held to spare capacity and the source of each new customer. And there are the inputs this valuation used, from the return on capital and the competitor map to the reproduction schedule, the scenarios and their probabilities, and every price reversed. The essay on inspecting SDE takes each item in turn as what a buyer inspects and how.