Adjusted Owner Benefit
The adjusted owner benefit is the standard way by which business brokers express what is commonly perceived as the net profits of a business. Some business brokers refer to the Seller’s Discretionary Earnings (SDE) when referencing the adjusted owner benefit. Many people simply look at the ‘bottom line’ net profit on a tax return or a profit and loss statement and stop their analysis. There is a large difference, however, between adjusted owner benefit of a business and the ‘net profit’ of a business that appears on a tax return (as taxable net profits) or a profit and loss report (as ordinary net income).
True Economic Profits for Working Owner
The adjusted owner benefit refers to the true amount of economic profits derived by a working owner of the business. In order to determine the adjusted owner benefit, one can start by examining the company’s financials (such as its tax return or profit and loss statement) and calculating the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). The EBITDA must be adjusted further, however, in order to uncover the true economic profits of the business as derived by a regular working owner under ordinary conditions.
Adjust EBITDA to Reflect True Owner Benefit
Major adjustments or add-backs to EBITDA include the owner’s personal expenses that flow through the financials as business expenses, rental adjustments to reflect current occupancy costs, and the owner’s salary along with salaries of the owner’s family. Unrecorded cash (if proven) may also be added back to a financial statement in order to derive the adjusted owner benefit. Business valuations are based on the adjusted owner benefit, so it is a good idea to fully understand this critical concept before buying or selling a business.
Adjust Owner Benefit for Owner’s Personal Expenses
The owner’s personal expenses that are expensed through the financial statement as business expenses must be added back as an owner benefit. Such expenses are not business expenses but rather are of direct economic benefit to the owner. For example, say the owner of an auto shop purchases a sailboat for $200K. Then the owner uses that $200K expense as a business expense in his financial statement (such as a tax return or profit and loss statement). So long as it can be verified that the $200K expense was not used for business purposes (but rather for the owner’s benefit), then the $200K should be added to the adjusted owner benefit.
Lenders Typically Do Not Count Personal Expenses as Owner Benefit
Many buyers of businesses use lenders backed by the Small Business Administration (SBA) in order to fund their transaction. As a part of the lending process, the SBA will appraise the value of the business. This appraisal may differ dramatically from what the buyer and seller of the business agree upon. Lenders do not typically count the owner’s personal expenses as being part of the adjusted owner benefit. Very seldom will a lender have an open mind and a willingness to go through the laborious process of verifying whether a company’s ‘business expenses’ on its tax returns or profit and loss statements are in fact the owner’s personal expenses.
Adjust Rental Costs to Reflect Reality
Some businesses have attached real estate which comes with the business. In such instances, business brokers must determine the fair market value of the monthly rent for the property (this should approximate the monthly costs of a mortgage and upkeep on the property). Then the business broker must determine how much rent (if any) the business paid (to whichever legal entity that owns the property) in its financial statement. The rental costs (if any) on the financial statement should be adjusted to reflect the actual fair market value of rent for the property.
Rental Adjustments to Owner Benefit if Seller Keeps Property
Also note that some business owners own attached real estate (such as a restaurant owner who owns the building where the restaurant operates), but wish to keep the real estate and rent the property to the buyer of their business. In such circumstances, the rental expense on the company’s financial statement should be similarly adjusted to reflect the rent that the seller is seeking from the buyer for use of her property after the sale.
Adjusted Owner Benefit Generally Includes Owner’s Salary
Many business owners choose to pay themselves as W2 employees. The owner’s salary is considered an economic benefit to the owner, and it is considered standard practice in most industries to have one active or working owner. The salary paid to this owner is then part of the adjusted owner benefit. Some buyers can not replace working owners with special skills or licenses. In such instances, not all of the owner’s salary should be included as a part of the adjusted owner benefit. Instead, the owner’s replacement cost must be determined and compared to the salary paid to the owner in the financial statement. The added back portion is the difference between the salary paid to the owner and their replacement cost.
Salaries for Owners’ Family Members Must Be Adjusted
If a business has multiple working owners or family members of the owner, then only the salary of one working owner should be considered an add-back when adjusting the owner benefit. Buyers can not be expected to replace more than one working owner by themselves, and would need to incur labor replacement costs in order to do so. The salary expenses for family members or multiple owners (except one owner) must be adjusted to reflect the costs to replace their labor. If anyone receiving a salary is not actually working in the business, then such labor costs are entirely considered to be an owner benefit.
Other irregular expenses (such as legal expenses) that an owner of a business may incur but which a buyer of the business will not incur are also considered a part of the adjusted owner benefit. Determining the adjusted owner benefit of a business is not an easy task, and requires the assistance of a professional business broker. In general, the owner’s personal expenses that flow through the financial statement, the owner’s salary, unrecorded cash (if proven) and adjustments to the rental costs all should be reflected in the adjusted owner benefit.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.