Owner’s Benefit – Earnings Definitions
By: Michael Fekkes, CBI – ENLIGN Business Brokers
Three of the more popular methodologies used to value a business are the Asset, Market, and Income approaches. This article will focus on the different types of earnings used within the income methodology and how they are used to value privately held small businesses. Under the income approach, businesses are valued based the earnings the company generates. The prospective buyer is typically focused on the amount of income that would be available to them should they purchase the business. The net ordinary income, calculated for tax purposes, does not depict the accurate earnings of the company based on the non-cash, discretionary, & non-recurring items expensed by the company owner. Earnings are intentionally kept low to mitigate income taxes. Therefore, to determine the true earning capacity of the company, the P&L needs to be re-casted to derive either SDE or EBITDA during the valuation process. Re-casting standardizes (or normalizes) the business earnings through the elimination of non-recurring, variable and discretionary components, allowing an objective and accurate comparison to be made between two businesses. The company value is then computed by applying a multiple, consistent with the industry and a weighting of the factors affecting the business, to the EBITDA or SDE amount.
Seller’s Discretionary Earnings:
Seller’s Discretionary Earnings is generally utilized for businesses with under $1,000,000 in adjusted earnings. These businesses typically have the owner operating and receiving a salary through the company. With these small businesses it is important to determine what the ‘owner benefit’ is as opposed to the ‘earnings’ of the business. This is accomplished through a series of P&L adjustments termed ‘add-backs’ that are made to the pre-tax business earnings. In certain circumstances, there are negative add-backs as in the case with a business that owns the building where the owner is paying himself a below market rent or a family employee performing a critical business function who is receiving a below market wage. In both of these cases, an adjustment is made to normalize the expense to a fair market value. The most common adjustments in the re-casting process are as follows:
1. Add-back one owner’s total compensation
a. Salary
b. Payroll Taxes
c. Perquisites (Health Club or Golf Memberships etc)
d. Insurance
e. 401K / Retirement Contributions
2. Add-back Non-recurring expenses
a. Bank Penalties or Fines
b. Attorney fee’s (e.g. related to sale of business)
3. Add-back interest expense
4. Add-back discretionary expenses (not necessary in the operation of business)
a. Owner’s Vehicles
b. Donations
c. Travel & Entertainment
d. Non-Essential Cell Phones
5. Adjust Lease or Rent to current market value
6. Add-back non-cash expenses
a. Depreciation
b. Amortization
Earnings Before Interest Taxes Depreciation Amortization:
EBITDA is used to define the earnings for larger companies, with adjusted income in excess of $1,000,000. In most cases, the business owner does not actively direct the company operations and must remunerate a general manager to perform that function. Therefore, the EBITDA formula will differ from SDE as it incorporates the manager’s compensation in the earnings calculation as an expense. EBITDA is a non-GAAP measure that is used to determine profitability and to make comparisons between businesses and sectors because it eliminates the effects of accounting and financing decisions. An effective means to determine EBITDA is to subtract the owner’s compensation and benefits from SDE. While the EBITDA number will be lower than SDE, the multiple used in the valuation is typically higher, often 2-2.5 times the SDE multiple. Thus, as one would expect the fair market value of the same business calculated using either method should be close to one another. If this is not the case, a determination as to why and which (or what other method(s)) must be undertaken.
Michael Fekkes is a Senior Broker at ENLIGN Business Brokers in Nashville, TN. Michael is a Certified Business Intermediary CBI®, a member of the International Business Brokers Association IBBA®, as well as a former business owner. He can be reached at 910.691.2202 or mfekkes@enlign.com. ENLIGN Business Brokers (www.enlign.com) is a Professional Services Firm that is headquartered in Raleigh, NC providing confidential business intermediary services to buyers and sellers throughout the United States.
