Understanding Seller Discretionary Earnings

After doing this for so many years, I forget not everyone understands the accounting aspects of business and the formulation that business brokers use to discern the net. I recently had a bad experience with a buyer that was irate that the tax returns didn't match what I wrote the net was on the business. Obviously, this person never owned his own business before and did not understand one fundamental thing, business owners do not want to pay tax.

Living in the state of California has many advantages like the weather and beauty but what it doesn’t have is a good tax advantage for business owners. Luckily the government allows you to reduce your tax basis by allowing you certain deductions that are not necessarily relevant expenses to the buyer. In addition, business brokers are all suppose to follow the same mathematical procedure for discerning the true net, this is called the sellers discretionary earnings. I say the "true" net because, as it pertains to the buyer, it is the true net. A buyer should only be concerned with how much money the business will make him/her, not how much it made the previous owner.

The first thing I do as a business broker is to carefully review the seller’s tax returns or P&L. I look at the bottom line and then I "add back" certain expenses that are, not relevant to the business, accounting expenses, onetime expenses, and the owners compensation.

Examples of non relevant expenses would be the sellers car related expenses (if he doesn't do deliveries), his cell phone bill (if he’s in the office all day and they have a landline), his medical insurance (if no employees are receiving medical) and expenses that would no longer apply. A good example of this would be equipment. In this case let's say the seller made equipment payments of $500 a month and this reduced his net profit by $6,000 for the year, but the equipment will be paid off when the buyer gets the business. I can add back the $6,000 to net because this is an expense that the buyer will not incur.

Accounting expenses are depreciation, amortization & interest. Depreciation is technically a real expense because things do need to be replaced eventually but the schedule is up to you and your accountant. Amortization is much like depreciation of assets but can also show up on tax returns along with depreciation. Interest would be the interest the seller paid on his loans to operate the business. In business brokering math, we always assume the buyer has cash and will not be paying a loan.

One time expenses are anomalies that don't normally occur. A good example of this would be a renovation of the business, that’s something that won’t happen every year. In restaurants, you could have a restaurant that always spends $2,800 a year in maintenance and repairs but one year has $13,000 expense due to a compressor going out. If the restaurant only has 1 fridge, that will be good for at least 10 years with proper maintenance.

Sellers/officers compensation is an add back because a seller can pay himself whatever he wants. His work in the company usually doesn’t have a defined value. We always assume that there’s 1 seller and he/she works 40 hours per week. Assuming this, if the business is absentee then we may add back the manager's salary. However, we cannot advertise that the business is absentee and then do this add back. You may indicate that the business is absentee but in your financial information that you provide you must indicate that you have added back the manager’s salary to reflect a owner operator.

Now if there's a husband and wife, it will depend on their individual involvement in the business, same applies with partners. If 1 person could do both their jobs then you can add back the whole thing but if they both work full time in the business then you must add in a salary to replace that person.

Every business broker has a different style in the way they present their listings so if you aren’t sure then ask. Please understand that there are many ways to present information but only one thing really matters, how much money is going to end up in your pocket if you buy this business? I support the purchase of all types of businesses, even those that don't make money, but that is as long as you know what you’re getting to. Business brokers don't get the financial information wrapped up in a tidy little bow from their sellers, it often takes weeks to sort through their mess to see what's missing, what's wrong and what doesn't add up but in the end we are only as good as the information that's given to us.

So remember, it's your responsibility to ask the right questions, get the assistance you might need from an accountant or attorney and decide if the business is really for you.