You will hear this bit of wisdom from business appraisers and brokers: small business financial statements need to be adjusted before they can be used in a business valuation. More mistakes are made in business appraisals due to incorrect earnings choices than for any other reason.
Most small businesses are managed to reduce taxes. Not surprisingly, accounting measures of profitability such as net income are generally unsuitable for business valuation. If you need an accurate business appraisal, focus on the cash flow based earnings instead.
Business earnings basis in small business appraisals
For small businesses that are managed by their owners the Seller’s Discretionary Cash Flow (SDCF) is the typical earnings basis to use. Here is the standard definition of SDCF, accepted by the International Business Brokers Association:
- Business pre-tax earnings
- Plus total compensation for a single owner.
- Compensation of other working owners adjusted for market rates.
- Plus non-operating and discretionary expenses.
- Plus interest and depreciation expenses.
- Plus one-time or unusual expenses.
The rationale behind the way the owners’ compensation is handled is this:
Assuming the business is to be sold, all current owners are expected to depart. The buyer is likely to be replacing the principal owner and thus will take over that owner’s compensation package. In addition, the buyer will need to hire management replacement to handle the duties of the other working owners.
The questions are:
- What tasks do the current owners perform in the business?
- What is the current owners compensation?
- How does it compare to the typical salaries for non-owner managers handling the same tasks in similar businesses?
Needless to say, the way these questions are answered can have a considerable effect on the business cash flow going forward. Some typical situations the buyer is likely to face:
- Current business owners are underpaid for the work they do. This will require that the business come up with additional funds to replace the owners. The effect is to reduce the available cash flow, and the SDCF basis used in business appraisal.
- Current business owners are overpaid relative to their contribution to the business. The excess cash flows to the new business owner after the replacement managers salaries have been paid.
- Current business owners do not contribute substantially to the ongoing operations. Their entire compensation is thus discretionary.
Effect of owners compensation on business valuation
The additional cash outlay for key management functions reduces the business discretionary cash flow. This, in turn, will lead to lower business valuation results.
On the other hand, excess owner compensation is discretionary. This increases the business SDCF basis. The result can be a higher business valuation.
You need to have a solid understanding of what the current business owners do, who will be leaving the business, and how their compensation compares to the market rates should they need to be replaced.
Even if you do not plan to sell the business, consider the effect on future business earnings of a departing co-owner who possesses critical skills. Are these skills readily available on the market at a reasonable replacement cost? The way you answer this question can make a big difference to what the business is worth.