In the small business arena, purchasers are often looking to buy a business and manage it themselves. This type of transaction, referred to as “purchasing employment,” is typically executed at a value that is based on some multiple of seller discretionary earnings. With all else equal, the greater seller discretionary earnings are, the greater the value of the business will be.
To calculate the seller discretionary earnings benefit stream, a business valuation analyst starts with the earnings before interest taxes and depreciation/amortization (EBITDA) of the business, then adds back expenses that are discretionary in nature and which provide a direct benefit to the owner. Seller discretionary expenses include the personal use of company vehicles by owners and relatives, owner compensation, owner health insurance, owner life insurance and any other personal expenses being charged to the business. Adjustments should also be made during the valuation process to account for any free work provided by a spouse or relatives. For example, if the spouse provides free social media management for the owner, he/she would likely need to be replaced by a new hire or outsourced marketing when a new owner takes over.
It’s clear that seller discretionary earnings give a clear picture of the true benefit the seller receives from the small business. Another reason it is so commonly used is that it’s difficult to separate such personal expenses from the necessary operations of a small business. Even if this could be sorted out with 100% certainty in the business being valued, it is unlikely that there would be usable sample of comparable businesses.
Whether a business is being valued by an independent business valuation analyst for a hypothetical value, or by one advocating for the seller or buyer, confidence will be greatest for all parties involved if any discretionary expenses are well documented. In order to increase the value of the business, owners should retain records and documentation to support their case that expenses are discretionary. A potential purchaser will likely scrutinize these expenses and make the argument that many of the expenses are truly business-related and should not be added back. In this instance, the owner with thorough records and documentation to prove the nature of these expenses will likely earn a higher valuation for their business. In an independent valuation, a valuator is required to use judgement in determining which adjustments should be made to earnings to accurately calculate seller discretionary earnings and having access to adequate records takes away any guesswork.
To learn more about business valuation, be on the lookout for upcoming articles or reach out to me directly.
Brandon Mitchell, CVA
Owner/Certified Valuation Analyst
BLM Valuation Services, LLC
About the author: Brandon Mitchell is a Certified Valuation Analyst and owner of BLM Valuation Services, LLC. BLM specializes in certified independent business valuations for SBA lenders and small business owners.