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
By Dan Browning, founder and President of DB Consulting, Inc., and a GABB Affiliate member
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).
Business Valuation Theory and Practice – Part One: Valuation Approaches
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!
GABB Spring 2019 Discretionary Earnings DBC
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
Federal Reserve Pauses Rate Actions, More Rate Cuts Predicted
ATLANTA–The U.S. economy is transitioning to a new growth path and production-level shocks in the system can derail its momentum, according to Rajeev Dhawan of the Economic Forecasting Center at Georgia State University’s Robinson College of Business.
One shock, the indefinite grounding of all Boeing 737 MAX planes, is domestic in nature and bad news for parts suppliers, especially in the face of already weakened corporate capital expenditures over the past six months. The other shock, stress on the world oil supply from geopolitical issues (warlord activity in Libya, unrest in Venezuela, U.S. sanctions on Iranian oil exports), is global.
“Shocks become a problem when the economy transitions to a new equilibrium, as it is now,” Dhawan wrote in his “Forecast of the Nation” released May 22, 2019.
2018’s strong growth rate was set in motion with the Tax Cuts and Jobs Acts of 2017, which, Dhawan said, “provided a type of fiscal stimulus, a positive change in the investment climate and job growth one-third higher in the first half of 2018 than the normal monthly job creation pace of 2017.”
The boost to investment spending petered out in the second half of 2018 because of numerous factors, chiefly stock market volatility from trade skirmishes and softening global growth. But other factors changed as well. The Federal Reserve undertook four rate hikes in 2018 but has paused further action since December. The length of the pause, and whether the Fed’s next action is a hike or a cut, will depend on how uneventfully the economy transitions to its new growth path. So far, the transition has been more eventful than not.
Retail sales were hit hard by a steep decline in the stock market. After growing 6.1 percent in the second quarter of 2018, retail sales moderated to just 1.0 percent by the fourth quarter.
As a result, “the positive income effect from rising job growth got wiped out by negative wealth effects emanating from stock market carnage,” the forecaster said.
Dhawan expects the Fed to begin rate cuts in December 2019, with a total of three by mid-2020.
As for tariffs on China, Dhawan said “The immediate impact is minor. Future impacts, especially reduced corporate desire for investment, will not be apparent for some time.”
Highlights from the Economic Forecasting Center’s National Report
- GDP growth of 2.9 percent in 2018 will moderate to 2.6 percent in 2019, moderating further to 1.9 percent growth in 2020 and 2021.
- Investment growth will moderate from 6.9 percent in 2018 to 3.7 percent in 2019, then to 3.4 percent in 2020 and rise to 3.6 in 2021. Monthly job gains will moderate to 179,100 in 2019, drop to 121,000 in 2020 and gain a similar 129,900 jobs in 2021.
- Housing starts will average 1.221 million in 2019, 1.239 million in 2020 and 1.262 million in 2021. Vehicle sales will be 16.5 million in 2019, 16.0 million in 2020 and 15.9 million in 2021.
- Even in the face of expected Fed rate cuts, the 10-year bond rate will average 2.7 percent in 2019, rise to 2.9 percent in 2020 and rise further to average 3.3 percent in 2021.
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Georgia Economy in 2019 Started Strong Due to One-Time Factors
ATLANTA–Strong employment gains during the first quarter of 2019 – particularly in hospitality, retail trade and temp employment – were most likely due to one-off factors, such as hosting Super Bowl LIII on top of other championship games, according to Rajeev Dhawan of the Economic Forecasting Center at Georgia State University’s Robinson College of Business.
“Georgia’s first quarter headline job gains were stellar, but there were one-time factors at play,” Dhawan wrote in his “Forecast of Georgia and Atlanta” released May 22, 2019. “Since there is not another equivalent big event on the horizon, the momentum created is already moderating as evident in April’s job loss numbers, which were concentrated in these hospitality and retail sectors.”
Annual employment benchmarking performed by the Bureau of Labor Statistics in March revealed Georgia’s job additions were downgraded from 103,500 in previously reported data to 89,000 in the benchmarked numbers. Analysis also revealed that globally connected sectors (such as corporate, manufacturing and information) showed continued moderation in job growth.
“Job growth moderation in globally connected catalyst sectors will trickle down into domestically demand driven sectors, (retail trade, hospitality) and result in a continuation of moderation of overall employment growth,” Dhawan said.
Metro Atlanta is expected to experience moderation similar to the state overall, according to the forecaster, especially because Atlanta contains most of the state’s Fortune 1000 companies.
“One continuing concern is where to find all the tech jobs we read about in the media,” Dhawan said.
His hypothesis is that some technology jobs are being counted in other sectors.
“Georgia is home to many technology companies in healthcare, particularly in the Atlanta area (GE Healthcare, Intermedix and McKesson Technology Solutions) and finance companies (Global Payments, NCR and TSYS),” Dhawan said. “Tech jobs may be counted in those sectors instead.”
Looking beyond Atlanta, recent job manufacturing announcements have brought positive news. The state announced groundbreaking on the Georgia International Trade Center in Effington County, and Plastics Express, a resins manufacturer, announced two new facilities in Savannah.
Highlights from the Economic Forecasting Center’s Report for Georgia and Atlanta
- Georgia employment will add 76,600 jobs (14,700 premium jobs) in 2019, 61,700 jobs (11,200 premium) in 2020 and 53,500 (9,700) in 2021.
- Nominal personal income will grow 4.4 percent in 2019, another 4.9 percent in 2020 and 5.0 percent in 2021.
- Atlanta will add 54,400 jobs (8,900 premium jobs) in 2019, 40,600 jobs (8,000 premium) in 2020 and 36,300 jobs (7,400 premium) in 2021.
- Atlanta housing permitting activity will fall 21.2 percent in 2019, decline 8.8 percent in 2020 and fall another 3.5 percent in 2021.
Word Up: Best and Worst Words to Use in a Business For Sale Ad
By Peter Siegel, MBA is the Founder And Administrator of BizBen.com
When it comes to selling your business, the right words matter. Using the wrong words can prevent or delay a sale, says Peter Siegel, Founder of BizBen.
When you’re selling a small business online, the first 30 to 45 days are critical. So Siegel says you want to fine tune your text before posting your business for sale online!
He offers a glossary of “Best Words & Phrases” and recommends using them in your copy, but only if they are true. And he also recommends avoiding the “Worst Text & Phrases.”
Best Text & Word Phrases To Use In Your Business For Sale Ads
Good Books And Records
Real Estate Included
SBA Loan PreQualified
Verifiable Financials
Owner Is Retiring
Great Location
Owner Carry Back Note
Health Forces Owner To Sell
Owner Will Carry
Owner Financing
Growing Sales
Growing Revenues
Consistent Earnings
Stable Revenues
High Adjusted Net Income
Provable Cash Flow
Staff In Place
Absentee Run
Semi-Absentee Run
For Sale By Owner
Relocatable
Home Based
Training And Support Provided
Long Established
Employees In Place
Management In Place
Easy Operation
Easy To Learn
Training Will Be Provided By Owner
Room For Growth
Steady Clients/Clientele
Computerized Operations
POS System In Place
Updated Client Database
Good Track Record
Owner Will Train
Owner Will Carry A Note – Help Finance The Deal
Long Lease In Place
Great Lease Terms
Will Cooperate With Brokers And Agents
Worst Text & Word Phrases in Biz for Sale Listings
Potential!
Owner Must Sell
My Loss Is Your Gain
No Training Provided By Owner
Don’t Let This Opportunity Slip Away
Will Sell Quickly
Moving Must Sell Quickly
Location, Location, Location
Must Check This Out
Act Fast Before It’s Gone
Priced To Sell
Will Not Last
Money Maker
In A A+ Location
Must Move Quickly
Don’t Lose Out
Dumb Advertising Strategies & Text Choices:
– Using All Capital Letters On Words
– Listing No Financial Information (Or Very Little)
– Giving No Selling Price or Price Range
– Not Giving A General Location
– Giving Very Little Information In Posting
– Using Multiple Exclamations – like !!!!!!!! to make a point, etc.
About The Author: Peter Siegel, MBA is the Founder And Administrator of BizBen.com (established over 20 years!) and is a Business Purchase Financing expert (SBA and Non-SBA financing) – see BizBuyFinancing.com. He consults daily with California business buyers, owner/sellers, business brokers, and agents regarding buying and selling California small businesses. Call him today regarding advise on finding, buying, selling, financing a business purchase/getting pre-qualified (ask about the BizBen ProBuy and ProSell Programs for business buyers and owner/sellers, and brokers). He’ll also give you referrals to the best resources on buying and selling businesses, brokers, etc and a FREE copy of his eBooks “How To Find And Buy A California Business Successfully” or “Valuing And Selling A California Business Successfully” with any personal consultation/service. Peter Can be reached direct at 866-270-6278 (if you get voicemail please leave some good times to reach you and a detailed message – thanks).
Marketing Strategist to Speak Aug. 21
Diane Conklin is an internationally known author, entrepreneur, coach, consultant, marketing and business strategist, implementation specialist and speaker.
Find out how you can harness a marketing strategy to grow your business when internationally known author, marketing and business strategist Diane Conklin speaks on Wednesday, Aug. 21, to the Georgia Association of Business Brokers. The GABB is the state’s largest association of professionals dedicated to buying and selling businesses and franchises.
The GABB meets at the Georgia Association of Realtors at 6065 Barfield Road, Sandy Springs, GA, 30328, and the meeting will last from 10:30 a.m. to noon preceded by a free light breakfast networking session at 9:45 a.m. Rob Tamburri, CPA PFS, managing partner of Balog + Tamburri, CPAs, is the sponsor of the meeting.
Diane is a direct response marketing expert who specializes in showing business owners how to turn their businesses into money making machines using rapid profit acceleration, leveraged business growth and strategic implementation by integrating their online and offline marketing strategies, media and methods, to get maximum results from their marketing dollars with Complete Marketing Systems.
For more than 25 years Diane has been leading small businesses to bigger profits through her coaching, consulting, marketing funnels, systems, live events and by providing done-for-you services to clients all over the world. As the founder of Complete Marketing Systems, Diane has been involved in many campaigns grossing over $1,000,000.00 several times in her career, and she routinely helps people grow businesses to six figures, and beyond. Diane was voted Glazer-Kennedy Marketer of the Year for her innovative marketing strategies and campaigns and was nominated for Atlanta Business Woman of the Year.
The monthly meeting begins at 10:30 a.m. and is preceded at 9:45 a.m. by a free light breakfast and networking session. There is networking with coffee and pastries from about 9:45 to 10:30 and the meeting will last from about 10:30 to somewhere between 11:30 and noon.
The GABB is the state’s largest and oldest association of professionals who specialize in brokering the purchase and sale of businesses and franchises. Broker members help owners determine the asking price of their business, create marketing plans and strategies for selling their business, identify and qualify buyers, and have the knowledge, experience and skills needed to help maintain the confidential nature of the process. The professionals of GABB relentlessly pursue professional development so they can provide superior, ethical services for all customers and clients. Affiliate members include bankers, lawyers, appraisers, insurers and other professionals who work closely with brokers to help owners and buyers get to the closing table.
For more information about GABB, please contact GABB President Dean Burnette at 912-247-3209 or dean@b3brokers.com, or GABB Executive Director Diane Loupe at diane@gabb.org or 404-374-3990.