Valuation Based on Owner Benefit
The valuation of most businesses is based on a multiple of the most recent annual adjusted owner benefit of the business. Determining the adjusted owner benefit (or true economic profits derived by a working owner) is tricky and requires careful analysis. An accurately adjusted owner benefit enables the buyer to get a true picture of the future profits or cash flow that they can expect to derive from the business. Most businesses are valued for 2 – 4 x its annual adjusted benefit. The valuation range depends on a host of factors such as the growth rate of the business, physical assets of the business, and the degree of ownership involvement in the business. Business owners should obtain an accurate set of historical financial records so a qualified and experienced business broker may value the business accurately.
First Step: Determine EBITDA
The term EBITDA refers to Earnings Before Interest, Taxes, Depreciation, and Amortization. The purpose of using EBITDA is to get a better picture of a company’s real earnings by stripping out non-cash expenses, taxes, and the costs of debt or capital equipment. If the business is sold debt-free (usually the case), then EBITDA will more accurately tell a buyer the real cash flow of the business. The EBITDA of the business is different from the adjusted owner benefit, but it is still a good place to start.
An Example to Determine EBITDA
- Bill’s Cabinet Shop has $200,000 of taxable net income (or pre-tax income on its tax return).
- To determine the EBITDA, one must take this pre-tax income of $200,000 and add-back any interest, depreciation, and amortization expenses that appear on Bill’s financial statement such as a tax return.
- Let us say that the business incurred $20,000 of interest expenses in relation to the company’s vehicle debt.
- Additionally, let’s presume that the business incurred a $10,000 depreciation charge and a $30,000 amortization charge (which is debt service on loans or long term assets) for capital equipment.
- The EBITDA of Bill’s Cabinet Shop is thus $260,000 ($200,000 + $20,000 + $10,000 + $30,000).
Step Two: Determine ‘Adjusted Owner Benefit’
The EBITDA of the business does not necessarily incorporate the true economic profits derived by the owner of the business. The adjusted owner benefit is the preferred metric to use when gauging the profitability of a small business. Adjusted owner benefit adds-back salaries or management fees paid to the owners of the business, personal expenses of the owner that flow through the financial statement, unrecorded sales (if proven), and any other adjustments for expenses that a buyer of the business would not face. Such add-backs are hidden assets that benefit the owner and in reality constitute economic profits to the owner.
Owner Benefit Adjusted for Working Owner
- The owner-add backs not reflected in EBITDA should also translate into economic profits to the buyer of the business.
- This is true so long as the buyer does not need to incur costs to replace a working owner (or members of the owner’s family).
- If the buyer will need to replace the labor of the owner or working members of the owner’s family, then such replacement costs that the buyer may incur should be deducted from the owner benefit.
- An experienced business broker should analyze whether a ‘working owner’ is generally expected from most buyers within a specific industry.
- If the working owner has a high skill set (such as a working plumber), then it is reasonable to assume that a buyer will not be able or willing to replace the working owner with himself or herself.
- The financial statement must be generally examined to determine if any other irregular expenses would not be faced by the buyer and thus be added back to owner benefit.
Owner Add-Backs Common
In small businesses throughout South Florida, most owner have many add-backs of expenses that would not pertain to the buyer. It is the job of the professional business broker to uncover these hidden assets and incorporate them into the advertised owner benefit.
An Example of Adjusted Owner Benefit
- In the above example of Bill’s Cabinet Shop, the determined EBITDA was $260,000.
- Looking at the tax return more closely reveals other hidden assets that should be included in the adjusted owner benefit.
- The officer’s salary (paid to Bill) is $100,000.
- Additionally, Bill reveals that he expenses $10,000 of his personal vehicle costs through the ‘Auto Expenses’ category on the tax return.
- Lastly, it is revealed that the company pays a $30,000 management fee to Bill’s wife (who is not active in the business).
- These costs amount to $140,000 and are appropriately deemed to be owner add-backs.
- Such costs would not be borne by the buyer of the business.
- Thus the adjusted owner benefit of the business is $400,000 ($140,000 of owner add-backs plus $260,000 of EBITDA).
- Note, however, that Bill’s $100,000 salary may not be viewed as an add-back by some buyers if they can not replace Bill’s role in the business by themselves.
- The more active Bill is in the business, then the more potential costs a buyer will have to replace Bill’s role in the business.
Step 3: Apply Valuation Multiple
Once the annual adjusted owner benefit is determined, an experienced business broker must apply the valuation multiple in order to determine the correct valuation. Common valuation multiples range between 2-4x annual adjusted owner benefit, with larger and more established businesses often receiving a higher valuation multiple based on their superior competitive advantages. Factors used when applying a valuation multiple for most businesses include the growth rate, level of physical assets included in the deal, location and lease, customer concentration, total addressable market, and any discernible competitive advantages that the business may possess. Applying the valuation multiple must be put in the context in which similar businesses in the same industry are valued.
Deriving the adjusted owner business is the most critical step when it comes time to valuing your business, and can be a far more complex exercise than one may anticipate. Using the right valuation technique that incorporates owner add-backs along with the traditional EBITDA will result in the best possible asking price.
Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.