ValuAdder Business Valuation Blog

Small business value is driven by its earning power

It will come as no surprise to you that the value of a small business depends on how much money it makes. More so than the market comparisons or the size of the business asset base, its ability to generate adequate income for its owners defines what it’s worth.

Given this, you may wonder – when it comes to business valuation, what is the best way to assess the business earning power?

Earnings basis – the key reference point for business valuation

Your first thought might be – look at the company’s historic Income Statments and choose the standard measure of profitability such as Net Income or EBITDA. That should serve as an excellent earnings basis, right? Wrong!

The fact is that the vast majority of small busnesses are managed to minimize taxable income. As a result, what appears on your company’s tax returns may be a far cry from its true economic potential. OK, if not the profit, what then should you use as your earnings basis for valuing the business?

Cash is king: why accounting profitability measures don’t work for valuing a company

The answer is cash flow. As a business owner you need to decide what amount of money you can remove from the business without harming its ability to run smoothly. Just because the business nets a certain amount does not mean you can put your entire profit in your pocket. You may well overlook such critical requirements as the funds needed to buy additional inventory or invest in new business equipment.

While Net Profit and EBITDA account for the business income and expenses, cash flow lets you see how the money moves through the business. This gives you the “big picture” of where the money comes and goes – including changes in working capital, cost recovery through depreciation, investment and financing activities as well as owners distributions. That’s why seasoned investors use cash flow to determine the business earning power.

For valuing a small business, the most common measures of cash flow you will see are:

  • Seller’s discretionary cash flow (SDCF).
  • Net cash flow (NCF).

SDCF, also known as seller’s discretionary earnings (SDE), is a very popular measure of cash flow used for valuing small businesses. It is the preferred earnings basis for one of the most widely used small business valuation methods, Multiple of Discretionary Earnings. You can find the definition of SDCF in our Business Valuation Glossary.

In practical terms, you calculate SDCF by starting with the company’s pre-tax profit and developing a number of adjustments, commonly known as addbacks.

What are addbacks?

Addbacks are basically cash outlays that are made at the discretion of business ownership. As mentioned before, the starting point is business pre-tax earnings. This is because most small businesses are structured as the so-called pass-through entities for tax purposes such as sole proprietorships, partnerships, S corporations or LLCs. The owners pay taxes individually.

Addback No 1: single owner-operator entire compensation.

By convention, the entire compensation package for a single owner is added back to the pre-tax profit. If the business is offered for sale, this addback is pretty important – this amount transfers to the buyer after the sale closes.

Addback No 2: Manager replacement adjustment for other working owners.

If there are other owners who work in the business, their compensation is adjusted to market value. This is known as manager replacement. The idea is that the new buyer will replace the selling owner and take over the compensation. However, the buyer will have to replace other owners and will need to hire outside managers to perform their jobs. If these owners are paid above market, then the difference is additional earnings for the business buyer. If, on the other hand, the owners are underpaid, then the buyer will have to come up with additional cash to hire their replacements. This reduces the cash available.

Addback No 3: Non-cash charges such as depreciation and amortization.

The depreciation and amortization are “paper expenses” and do not impact the business cash flow directly. Business owners have considerable discretion in how to depreciate their assets. Hence, annual depreciation and amortization expenses are added back as well.

Addback No 4: interest expense.

The interest expense is added back because the new ownership can choose how to finance the business operations. For example, they may decide not to borrow any funds, pay no interest, and pocket the interest expense as additional income.

Addback No 5: non-recurring or one-time expenses.

Non-recurring expenses are another form of addbacks. These are incurred rarely and do not represent a normal business expense. Examples are moving expenses associated with business relocation to a new site.

Creative addbacks – what sticks and what doesn’t

When selling a business, some business owners are tempted to add back a number of other expenses to demonstrate superior earnings and, therefore, higher business value. Things like auto and cell phone expenses, trade show attendance and travel are common. These may well be discretionary and thus serve as justifiable addbacks.  On the other hand, trade show attendance may lead to legitimate business expenses required to develop new vendor and client relationships. If you must visit and entertain clients to get business, then travel and entertainment expenses are essential and not discretionary.

You can expect that the most common addbacks will most likely be acceptable to a savvy business buyer or lender offering business sale financing. But they will certainly scrutinize an addback schedule which bristles with creative addbacks – whose amounts far exceed the norm for your industry or those rarely seen for your type of business.