I received an email a few months ago asking a similar question.
“I am researching a company to purchase and having difficulty understanding Owner Benefits. If an owner takes a reasonable salary, why is this considered an Owner Benefit and added back into the Adjusted Net Income? If the owner did not take this, the work would still have to be done by another person and then it would be listed as a payroll expense for another employee, thereby deducted from Adjusted Net Income. I can see if it said “the salary” was above and beyond market rate, but not if it is a fair market salary and required as a function of the business... Your insight is greatly appreciated!!”
The profit figure you are looking for is called the EBITDA (Earning before deducting Interest, depreciation, taxes and amortization) This figure is similar to Owners Benefits except that a Fair Market Value Salary for the working owner has been deducted from the profit. Corporate America uses EBITDA because the manager usually does not own the company and as you have said, he must be paid before the stockholders can take a dividend.
Owner’s Benefits (sometimes called Adjusted Net Income) is designed for small main street businesses where the owner is working to make a living to support his family. He did not buy it as an investment or to be an absentee owner, but to work the business for money he can earn for his time and investment together. If he hired a manager the business may not make any profit at all or a profit so small it is not worth owning. These types of businesses are not designed for investment but to be owner operate. All profits of a small business accrue to the owner regardless of how labeled. The owner is buying the business and working it to make a living. A second family member working for free is not part of the Owner’s Benefits. The fair market value of the wages of the second working family member must be deducted as an expense. The Owner’s Benefit formula only allows one non-paid working owner, time to be included in the calculation. If two people were allowed to do this the ability to compare businesses would be impossible since some would have two free workers and others would only have one.
That being said lets clarify a few other points on this subject. Even through sellers do pay interest and taxes and have some real depreciating assets, these items are not deducted for purposes of determining the Owners Benefit or the EBITDA. That is because each person will have different numbers for each of these items and consistency is needed for comparison purposes.
Cash flow means different things to different people. It is supposed to be the amount of profit that the owner has to spend after he pays the business expenses. I define it as being the same as the Owners Benefits, SDE or Adjusted Net Income. Others may think it means something else. Get an exact definition when the term is being used.
I think I should also point out that if you are looking at an Owners Benefit number of $100,000, for example, that is enough to cover a salary of $50,000 and the balance as a profit from operations. The value of this business might be $150,000 to $200,000 based paying two times the business profit or Owner’s Benefit.
If you looked at EBITDA for this business it would be $50,000, based on this number a seller might ask $200,000. This is based on an assumption that a buyer will make a 25% profit on his investment and nothing for his time, since that is covered by the manager’s salary.
Depending on how you look at a business and why you are buying it should determine if you calculate the EBITDA or the Owner’s Benefit.