As I mentioned in my post on business valuation, the value
of a business is usually -almost always – dependent on earnings. But it is an adjusted earnings, called
Discretionary Earnings for small to mid-sized companies and EBITDA for larger
companies. Discretionary Earnings, for
example, is adjusted to make sure it is before taxes, interest and
depreciation. In addition, “owner’s
benefit” is also added back, and that is usually the most contentious
Owner’s benefit, by definition, is the benefit for ONE
owner. This means you add back the
salary, benefits, and perks of one owner.
Often we’ll see multiple owners (such as a husband / wife team) and in
this case only one of the salaries is added back. In fact, sometimes we see a spouse (yep,
usually the wife), working full time in the company and not getting paid at
all. In that case we have to do a
“negative addback” to account for the fact that a new buyer is unlikely to find
someone to work for free! By the way, if you are buying a company watch
out for this – some brokers will not adjust for a spouse’s free work and you
can overpay for a small company by a significant amount simply for the fact
that there is a salary missing from the expenses.
Other addbacks for owner’s benefit are health insurance,
life insurance, pension and then any owner perks, such as personal expenses
written off as company expenses. The purpose is to try to determine what a new
owner would enjoy by owning the company.
Sometimes it gets awkward when the owner is taking so many
“perks” that it really amounts to tax fraud.
Everyone does some tweaking, for example putting the families’ cell
phones into the company, writing off car expenses when the company doesn’t
really use a car, etc. These are
accepted as legitimate addbacks, interestingly even by the SBA, which is after
all a part of the government. You can
usually addback a few tougher items, like a son or daughter that is on the
payroll but isn’t actually working. But
at some point you have to draw the line (or the bank will draw one for you).
Other addbacks are one-time items such as moving expenses or
major repairs. I had one owner, having
read about how to do addbacks, that tried to convince me that tools, books and
just about everything he bought was a one time expense. That would only be the case if a new owner
never had to buy anything again. So as a
rule, only significant one-time expenses are used.
Once you have the correct addbacks added back into earnings,
you then have your Discretionary Earnings, and (theoretically), it can be used
to compare the company to similar companies, or even across industries for the
purposes of valuation or showing a new buyer what he/she can make from the business.