Business Valuation: Hidden in Plain Sight – Determining Seller’s Discretionary Earnings
Business Valuation Theory and Practice – Part Two: Hidden in Plain Sight – Determining Seller’s Discretionary Earnings
Disclaimer: This article and the accompanying slide deck are for educational purposes only. Nothing contained herein can be used against me in a litigation or other adversarial setting. Examples have been changed to protect the innocent (and not so innocent).
The precise definition of “Seller’s Discretionary Earnings” can vary from one database to another – and when I say “database” I’m talking about transaction databases, such as ValuSource (formerly IBA), BVR Stats (formerly Pratt’s), BizComps, etc. The very terms themselves can also vary, but the concept they’re after is similar – trying to determine the total economic benefits that flow to the owner of the business.
It’s also important to note that a business appraiser typically looks at “value” from the perspective of “fair market value,” which calls for the perspective of a “financial buyer” – a neutral party who’s just looking for a return on investment. This is actually rare in main street and small business deals – most of which involve owner-operators – but it’s the artificial way business appraisers have been taught to evaluate the fair market value of a business.
When it comes to small and midsize companies, financial statements have been known on occasion to stray a bit from standard accounting principles and practices. One of the more common areas where reported expenses tend to vary from actual ones (or, for that matter, from industry standards) is officers’ compensation. There are some legitimate reasons for these variations, but there are also some questionable ones. In either event, the shifting of corporate revenues to the compensation of owner-officers of a small company can significantly impact the cash flow numbers, and thus the perceived value of the company.
Often, owners will pay themselves a salary that’s lower than industry standards and take the rest of the revenues in pass-through income, which of course has the benefit of lowering personal taxes since they only pay ordinary income tax on the pass-through income, whereas the salary is also subject to Social Security and Medicare taxes.
Management usually determines compensation of owner-officers of a corporation from a tax-related standpoint. This means that if there are excess funds available at the end of the year, management might increase payouts in order to reduce the corporation’s taxable income to a very small figure. Also, management may conflate salaries with dividends, paying compensation as a return on the owner-officers’ initial investments in the company.
Other benefits could be considered to be part of a standard compensation package that might need to be offered to any candidate for the job, but they are still benefits that flow to the owner. Also, distributions or dividends may or may not need to be added back, depending on how they’re reported.
Owners can start getting a little testy when you push back against all the “benefits” they take out, so you have to approach this topic calmly and dispassionately, not accusatorily.
Practices that blur the line between legitimate and questionable compensation figures may include paying “salaries” of others, such as members of the owner’s family who contribute relatively little to the business in comparison to the compensation they receive (e.g., somehow Junior is on the payroll as a full-time employee even though he’s a sophomore at UGA). Other questionable practices include the payment of excessive compensation to related members of the board of directors, and corporate transactions with relatives of the owner-officer.
Owner’s perquisites in such forms as personal or family automobiles charged as a business expense (i.e., the “company Land Rovers”), travel and entertainment expenses that are at least partly personal (i.e., the “company board meeting in the Caribbean”), and personal insurance premiums charged to the business are also common tax-reducing aspects of income statements.
Once while out on a site inspection of a warehouse distribution facility, I asked the President whether there were any other significant assets that I had not seen. “Well,” replied the official, “there’s the boat around back.” Upon further inquiry, I discovered that this was a “company boat,” used by the boss/owner-officer to take his best clients out fishing in the Gulf of Mexico once a year. Fair enough, you might think. However, the owner’s family and friends also used this boat on a consistent basis for the other 51 weekends out of the year!
Dan Browning’s professional designations
- Master Analyst in Financial Forensics (MAFF) from the National Association of Certified Valuators and Analysts, originally awarded August 1999
- Accredited in Business Appraisal Review (ABAR) from the National Association of Certified Valuators and Analysts, originally awarded March 2010
- Georgia Association of Business Brokers (Affiliate Member)
- State Bar of Georgia (Active Member; Eminent Domain and Nonprofit Law Section Memberships)
- Editorial Board, Business Appraisal Practice (IBA Journal) 2013-2015