Super helpful - thank you! In your model, would re-investing in the business (e.g., software, new hires, new equipment, etc.) be equivalent to a larger replacement cost?
Not exactly -- those may be required to generate growth, but they're not required to generate the current level of earnings.
I think of replacement costs as the costs required solely to make the business as profitable as it is currently, but without the seller being there anymore.
Correct -- when you're underwriting a deal, you're looking at as investment (whether or not you bring in investors). That's a different process than figuring out your business plan, which is also important.
But don't conflate the two while underwriting, you know?
You mention the first year depreciation and goodwill deductions. Are the multiples more meaningful if they are viewed in light of the first two years or the 10 year life span of an SBA loan? With high FFE, my deal looks great in year 1 and 2. Not as much in following years
I try to think about underwriting on a "steady-state" basis. So I think I would include the goodwill amort, as that is 15 years of steady deductions, which is pretty steady-state IMO. But I would normalize down the depreciation to more closely reflect your ongoing maintenance capex needs.
Thanks for sharing, this is extremely helpful. One question - how should we think about the working capital in the Deal Uses? When we buy the business, it should come with the working capital already included - is the 10% assumption meant to reflect a cash buffer on top of that? Thanks!
In PE, the business comes with normalized working capital. In SMB, that's generally not the case -- the deals usually come with no working capital, so you need to bring cash to the table.
Given that fact, you need to lower your purchase price upfront to account for needing to bring cash. The good news is the SBA lender will finance the cash to balance sheet for you.
Yes, that's technically correct. You add back interest with a tax adjustment to get to unlevered free cash flow. Then when you subtract interest again to get to levered free cash flow, you unwind the tax adjustment. So Levered Free Cash Flow is unchanged. Honestly, just a simplifying adjustment I made above to avoid making the math too confusing.
Reality is that no one is buying these small businesses unlevered anyway, so unlevered free cash flow is more just a rough measure of safety relative to debt service. Levered Free Cash Flow and Usable/Distributable Free Cash Flow are closer to what people will experience in real life.
Thanks. That's helpful. I like that the model includes taxes. I've been spinning around a bit trying to determine how best to handle taxes in the valuation/cash flow as it's inconsistent across models. Some of the bank models calculate DSCR on EBITDA (buyer's ebitda, but no account for taxes to buyer). I kinda get it, but to me, taxes are a real cost that consumes cash and can't be ignored. So many definitions of cash flow, and -- to your point--impacts the multiple, and what it "means."
Yes & no - the reality is if you have fixed assets (vehicles & equipment), then in the first year of small business transaction, you will likely have zero taxes due to accelerated depreciation of those assets + 15-year amort of goodwill + interest expense. I had meaningful interest expense carryover in fact. And then I bought some new equipment that also has accelerated depreciation. So second year is also likely close to zero taxable income.
Eventually it's a real cost for sure -- but in the first couple years, the most important years, it's likely not.
Hey, I'm new to this field and your blog is a fantastic help! Really appreciate the quality content.
I have a quick question about the math on the Google Sheet, apologies if it's a basic one!
It's regarding the Buyers D&A which is depreciated over a 15 year period. In the net income figure on the top line, would this typically already have accounted for D&A?
What separates buyers D&A from your typically business assets D&A.
Hey Andrew -- when you receive financials from the Seller, their Net Income figure will typically have subtracted D&A from profits on the way to Net Income.
The big difference between buyers' D&A is that you can amortize Goodwill over 15 years.
When you buy a fixed asset (like a vehicle), that has specific depreciation terms that the IRS allows -- that's the depreciation most sellers will have on their P&L.
But when you buy a business for more than the value of its fixed assets (as is usually the case), the excess amount is logged as Goodwill (or other Intangible Assets). That amount can be depreciated over 15 years.
So if there are assets you're buying with the business that depreciate (vehicles, equipment, etc), would you just subtract that amount from the purchase price and divide that new amount by 15? Am I following that logic correctly?
And thanks so much for the walk-through! Very helpful.
Purely for the purposes of depreciation, that's roughly correct. The fixed assets can be depreciated immediately, the goodwill (remainder of purchase price) is amortized over 15 years.
Used this model as a template for a deal I just evaluated - very helpful, thanks for sharing. Had a thought on the Hirable FTEs line... If we're already allocating replacement costs to get to buyer's EBITDA shouldn't we add that to usable free cash flow to get the true amount of cash available for additional bodies? If we wanted to be even more realistic you'd probably want to tax-adjust the usable FCF number since any additional FTEs would be a taxable expense. Curious your thoughts on this...
Thanks Joseph! The idea is that replacement costs are related to just keeping the business steady (i.e. replacing the owners' duties that you can't/don't do yourself). The business wouldn't be able to operate without those hires, so it's not really "usable cash" as the earnings isn't real.
Whereas the hirable FTEs are true growth hires.
In practice, it looks more like "I need a 60% operations manager hire, but that other 40% of their time is growth-oriented). So in that case you could allocate 60% of their cost as a replacement cost, with the knowledge that the other 40% is coming out of your "usable cash". If you can't afford that 40%, you have a real problem as you can't afford the 60% either then, which you really need.
Ah, got it - makes sense. So, simply put, you think of the replacement costs as a sort of required "maintenance capex" and the hirable FTEs as a growth lever.
Super helpful - thank you! In your model, would re-investing in the business (e.g., software, new hires, new equipment, etc.) be equivalent to a larger replacement cost?
Not exactly -- those may be required to generate growth, but they're not required to generate the current level of earnings.
I think of replacement costs as the costs required solely to make the business as profitable as it is currently, but without the seller being there anymore.
Gotcha. Is this given that you are thinking of the investment more from an investor vs operator standpoint?
Correct -- when you're underwriting a deal, you're looking at as investment (whether or not you bring in investors). That's a different process than figuring out your business plan, which is also important.
But don't conflate the two while underwriting, you know?
You mention the first year depreciation and goodwill deductions. Are the multiples more meaningful if they are viewed in light of the first two years or the 10 year life span of an SBA loan? With high FFE, my deal looks great in year 1 and 2. Not as much in following years
I try to think about underwriting on a "steady-state" basis. So I think I would include the goodwill amort, as that is 15 years of steady deductions, which is pretty steady-state IMO. But I would normalize down the depreciation to more closely reflect your ongoing maintenance capex needs.
Thanks for the note. Super helpful!
Glad it helped!
This is so useful. Thanks for putting the spreadsheet and post out there!
Glad you found it helpful! Thank you!
We’re using this right now on a deal so immediate application
Thanks for sharing, this is extremely helpful. One question - how should we think about the working capital in the Deal Uses? When we buy the business, it should come with the working capital already included - is the 10% assumption meant to reflect a cash buffer on top of that? Thanks!
In PE, the business comes with normalized working capital. In SMB, that's generally not the case -- the deals usually come with no working capital, so you need to bring cash to the table.
Given that fact, you need to lower your purchase price upfront to account for needing to bring cash. The good news is the SBA lender will finance the cash to balance sheet for you.
Thanks, good to know!
Thanks for this model and all the posts--super useful! And really appreciated.
I have a question on how the financial model goes from Buyer Net Income (NI) to Unlevered Free Cash Flow (aka FCFF).
When going from Net Income to FCFF
--the model adds back interest with no tax adjustment
--I would have thought Interest would have been INT (1- TAX RATE).
--per formula for FCFF to NI --> FCFF = NI + D&A +INT(1 – TAX RATE) – CAPEX – Δ Net WC.
How do you think about this? Thank you!
Yes, that's technically correct. You add back interest with a tax adjustment to get to unlevered free cash flow. Then when you subtract interest again to get to levered free cash flow, you unwind the tax adjustment. So Levered Free Cash Flow is unchanged. Honestly, just a simplifying adjustment I made above to avoid making the math too confusing.
Reality is that no one is buying these small businesses unlevered anyway, so unlevered free cash flow is more just a rough measure of safety relative to debt service. Levered Free Cash Flow and Usable/Distributable Free Cash Flow are closer to what people will experience in real life.
Thanks. That's helpful. I like that the model includes taxes. I've been spinning around a bit trying to determine how best to handle taxes in the valuation/cash flow as it's inconsistent across models. Some of the bank models calculate DSCR on EBITDA (buyer's ebitda, but no account for taxes to buyer). I kinda get it, but to me, taxes are a real cost that consumes cash and can't be ignored. So many definitions of cash flow, and -- to your point--impacts the multiple, and what it "means."
Yes & no - the reality is if you have fixed assets (vehicles & equipment), then in the first year of small business transaction, you will likely have zero taxes due to accelerated depreciation of those assets + 15-year amort of goodwill + interest expense. I had meaningful interest expense carryover in fact. And then I bought some new equipment that also has accelerated depreciation. So second year is also likely close to zero taxable income.
Eventually it's a real cost for sure -- but in the first couple years, the most important years, it's likely not.
I like your google sheet! I am trying to add scenarios for seller notes and a preferred equity investor.
Any thoughts on how to set it up to quickly look at potential investor returns? https://docs.google.com/spreadsheets/d/1FSylZBt1zsPRwVvDsRiO7E1TufEBU8NVuES5D8tXzb8/edit?usp=sharing
Participating Preferred Equity (how most search deals are structured) are effectively the same thing as a loan + common equity.
So the easiest way to do it is to just set up the two parts of return:
- a "loan" for the pref rate, though you can have the interest just accrue and paid at exit
- common equity for whatever % they get of the exit
Then add them up for the pref investors' total return.
Hey, I'm new to this field and your blog is a fantastic help! Really appreciate the quality content.
I have a quick question about the math on the Google Sheet, apologies if it's a basic one!
It's regarding the Buyers D&A which is depreciated over a 15 year period. In the net income figure on the top line, would this typically already have accounted for D&A?
What separates buyers D&A from your typically business assets D&A.
Thanks!
Hey Andrew -- when you receive financials from the Seller, their Net Income figure will typically have subtracted D&A from profits on the way to Net Income.
The big difference between buyers' D&A is that you can amortize Goodwill over 15 years.
When you buy a fixed asset (like a vehicle), that has specific depreciation terms that the IRS allows -- that's the depreciation most sellers will have on their P&L.
But when you buy a business for more than the value of its fixed assets (as is usually the case), the excess amount is logged as Goodwill (or other Intangible Assets). That amount can be depreciated over 15 years.
So if there are assets you're buying with the business that depreciate (vehicles, equipment, etc), would you just subtract that amount from the purchase price and divide that new amount by 15? Am I following that logic correctly?
And thanks so much for the walk-through! Very helpful.
Purely for the purposes of depreciation, that's roughly correct. The fixed assets can be depreciated immediately, the goodwill (remainder of purchase price) is amortized over 15 years.
There's technically seven classes of assets though, not just two, so here's a deeper discussion: https://www.kerr-russell.com/the-significance-of-purchase-price-allocation/
Great, thanks for clarifying!
Used this model as a template for a deal I just evaluated - very helpful, thanks for sharing. Had a thought on the Hirable FTEs line... If we're already allocating replacement costs to get to buyer's EBITDA shouldn't we add that to usable free cash flow to get the true amount of cash available for additional bodies? If we wanted to be even more realistic you'd probably want to tax-adjust the usable FCF number since any additional FTEs would be a taxable expense. Curious your thoughts on this...
Thanks Joseph! The idea is that replacement costs are related to just keeping the business steady (i.e. replacing the owners' duties that you can't/don't do yourself). The business wouldn't be able to operate without those hires, so it's not really "usable cash" as the earnings isn't real.
Whereas the hirable FTEs are true growth hires.
In practice, it looks more like "I need a 60% operations manager hire, but that other 40% of their time is growth-oriented). So in that case you could allocate 60% of their cost as a replacement cost, with the knowledge that the other 40% is coming out of your "usable cash". If you can't afford that 40%, you have a real problem as you can't afford the 60% either then, which you really need.
Ah, got it - makes sense. So, simply put, you think of the replacement costs as a sort of required "maintenance capex" and the hirable FTEs as a growth lever.
Exactly.