Owner's Salary - include in earnings?
April 16, 2018
by an investor from University of California, Berkeley - Haas School of Business in Moorestown, NJ 08057, USA
I have been looking at a lot of broker-supplied deals. To a one, when they calculate SDCF they include the full owner's salary to the last penny. In the HBR Guide to Buying a Small Business it says to exclude the amount of a fair market salary for a general manager when calculating earnings and thus the offer.
Opinions on this?
from Boise State University in 800 W Main St, Boise, ID 83702, USA
Sometimes buyer prospects tell me, that in their opinion, a business is only "worth" a multiple of###-###-#### for example), I ask them, "how did you calculate the multiple?" What definition of earnings was used? An SDE multiple may be 3., EBITDA multiple, may be 4 and Revenue multiple may be .50 for the same company! None of it means anything unless the earnings are sufficient for you to pay yourself a living wage, pay back the debt to purchase the business, and show an acceptable (to you) return on your cash investment.
There is a difference between the Market Approach and the Income Approach to value.. In the Market approach, SDE is used for "main street" size businesses (let's say under $2,000,000 in value), where the buyer is primarily purchasing a job and using SBA and maybe seller debt to finance it. SDE (Seller's Discretionary Earnings) is the sum of net profit plus owner's salary (not draws), plus any depreciation expense, plus any interest expense, plus any owner perquisites (think "adjustments to improve earnings such as add back of owner personal use of vehicle, non-recurring expense normalization, etc). The SDE amount includes all owners salaries. For example, if the SDE is $300,000 and the sold business database, Bizcomps, shows that a median SDE multiple for this industry is 2.50, you would multiply $300,000 x 2.5 which means the company may be "priced" at $750,000.
When using the Income Approach to Value, one owner's salary is removed from the earnings. Using the prior example, the business has an SDE of $300,000 ( which includes one owner's salary of $75,###-###-#### Under the Income Approach, the net earnings, after one owner salary, (let's call it EBITDA) is $225,000. Here's the math $300,000 SDE - one owner salary of $75,000 = $225,000. Keep in mind that the EBITDA multiple will NOT BE the SAME as the SDE multiple. Typically, EBITDA multiples are larger than SDE multiples.
To keep it simple, let's say that the EBITDA median multiple for the business is 3.33. $225,000 x 3.33 = $750,000. The calculated "value" is the same as above. However, the formula to get there is different.. Which way is "right" or "best"? It depends. In my opinion, as a business appraiser and broker, for main street sized businesses, SDE is most commonly used and works best for the smaller companies. The sold business databases sometimes show both the EBITDA and SDE multiples. However, SDE and EBITDA multiples are calculated differently. All roads lead to the same destination. Hope this helps.
from University of Southern California in North Palm Beach, FL, USA
"Don’t believe “discretionary” cash flow can pay debt.
Don’t think “discretionary” cash flow is available to finance debt.
"Is owner’s salary discretionary? Is health insurance? Is depreciation? Absolutely not. Treating these as though they are discretionary expenses is a big mistake. Doing so means you earn less than the business would spend to compensate a manager. It could cause the business to become insolvent and lead to a fraudulent conveyance, which puts your personal assets at greater risk. Use the business’ net profit—after fair owner comp—to retire debt."
Much more on topic:
https://partneroncall.com/how-to-buy-the-right-business-the-right-way/