Why it matters
Businesses in the same trade tend to land in a similar range of margins, because they pay similar prices for materials, labour, premises and customers. When a listing shows margins well above that range, the business may have a real advantage, such as a strong brand, a protected product or genuine pricing power. More often, some costs are missing from the figures.
The usual reasons are:
- The owner or family members work long hours without market pay.
- The business pays little or no rent because the owner owns the premises.
- Maintenance, marketing, training or hiring has been cut ahead of the sale.
- Some costs are paid by another company the owner controls.
- Closing stock (inventory) has been overstated, which understates the cost of sales.
- Revenue includes one-off items or has been recognised early.
Each of these means the profit you would earn as the new owner is lower than the profit in the listing, and paying a multiple of an inflated figure multiplies the error.
Loupe's valuation tool runs a sanity check for this. It flags a profit margin above 50%, measured as SDE against revenue, for businesses other than software and content. Treat the result with caution until the margin is explained. That is a wide net. A margin below that line can still be implausible for a particular trade, so compare with businesses that do the same work.
Seller's discretionary earnings (SDE)
Seller's discretionary earnings is the yearly financial benefit a business gives one full-time working owner, before financing costs, non-cash charges and one-off spending.
How to spot it
Compare gross margin and net margin with similar businesses: comparable listings, trade association benchmarks, competitors' published accounts where they exist, and advisers who know the sector. Then look for:
- Margins that rose sharply in the last year or two while revenue did not.
- Wage costs that look low for the headcount, opening hours or volume of work.
- No rent line, a low rent, or rent paid to a person or company connected to the owner.
- Marketing or repairs spending that has dropped towards zero.
- Gross margin that swings from year to year as the closing stock figure changes.
Gross margin is revenue minus the direct cost of what a business sells, shown as a percentage of revenue. It shows how much each sale contributes towards overheads and profit.
Questions to ask the seller
- Why do you think your margins are higher than those of similar businesses?
- What work do you and any family members do, and how are you paid for it?
- What rent does the business pay, and to whom?
- Which costs have you reduced in the last two years, and what effect has that had?
- How is stock counted and valued at the year end?
- Are any of the business's costs paid by another company or by you personally?
Documents to request
- Monthly profit and loss statements for the last 36 months
- Payroll records and an organisation chart showing hours worked by owners, family and staff
- The lease and any agreements with related parties
- Year-end stock count sheets and the stock valuation method
- Recent supplier invoices for the main materials or services the business buys
- Repairs, maintenance and marketing ledgers for the last three years