How to Buy a Business with a Business Broker

Category: Business Valuation Buying a Business 
Bill Grunau

Are you thinking about buying a business to build your future, gain personal freedom and independence but not sure where and how to start?  How do you get started and find the right business?  What are the steps involved to find the best business for you?

Before you start your search for the right business, we suggest you step back and look at what types of businesses are for sale.  It will surprise you how many different types of businesses there are.  We also recommend keeping an open mind with respect to business types and look at broad industries, even look at some that you had not necessarily considered.  

  1. Search & Identify Prospective Businesses:
    The first step involved is to search the businesses for sale listing sites such as Bizbuysell.com, Bizben.com, CABB.org etc. There are a wide range of businesses available at any given time in a variety of industries. You will be able to search by industry and location plus the amount of earnings and price that fits your financial situation.
  2. Get Your Finances & Financing Together:
    Before you inquire about a business for sale get your finances in order.  How much cash do you have for a down payment?  Remember you will also need working capital for operating expenses, closing costs etc.  If you are going to use SBA financing (which we highly recommend) you will be able to leverage your down payment to buy a much larger company.  See our SBA financing page for more information on using SBA financing to buy a business. 
  3. Inquire about the business:
    When you find a business that you are interested in, submit an inquiry from the listing site and you will be sent a Confidentiality Agreement and Buyer Profile to fill out and sign.  Your inquiry will usually go to the listing broker for the business.  Make sure you fill out the Buyer Profile completely, including providing the requested financial information.  Brokers will not provide any confidential information about the business for sale without a complete Buyer Profile and if you do not provide financial information they will assume you are not qualified.  The majority of business sales are Dual Agency transactions, which means the broker represents both buyer and seller in the transaction.  This is common in business brokerage.  
  4. Sign NDA & Receive Confidential Information Memorandum or Business Profile:
    After you have signed the confidentiality agreement and buyer profile the broker will review both to determine if you are qualified to purchase the business. If everything is signed and you qualify you will be sent a Confidential Information Memorandum (CIM). The CIM should have enough information in it for you to determine if you are interested and want to move to the next step.  Be careful not to rule out a business too quickly because the business profile (CIM) lacks detail.  While our firm, Pacific Business Sales, prepares comprehensive business profiles, most brokers prepare a very brief overview of the company.  If the company looks interesting, give it the benefit of the doubt and contact the broker for more information.  
  5. Contact Broker for more info:
    The next step is to contact the broker that provided you with the CIM to discuss the opportunity, provide your background, and if you are interested ask the broker to set up a meeting with the seller to further discuss the business.  Again, if it looks interesting, go ahead and set up a meeting.  Buyers often have the expectation that everything they need to know will be in the CIM or obtained in a quick phone call with the broker and often prematurely pass on a business without really learning about it.  You won’t buy a business from your laptop in your pajamas at home, you have to go to the business, meet the owner, and learn about it.  
  6. Seller Meeting & Visit Business:
    At the seller meeting you will be able to discuss the operations of the business, the sellers role, customer concentration, marketing, employees and their rolls, and general questions about financials such as average inventory, A/R and backlog. There may be other questions depending on the type of business and industry.  The first meeting is not the time for asking detailed questions about the financials and tax returns or to start asking the seller to prove his figures, that is done after an offer is made during due diligence.  During Due Diligence you will have full access to the company financials and plenty of time to drill down into the details to prove the revenue and earnings of the business.  Note in many cases there may be more than one Seller meeting.  Consider the first one an introduction and the second one is where you learn more about the details of the business.  
  7. Write an Offer:
    After your Seller meetings and perhaps some additional phone calls with the broker you will have enough information to write an offer for the business. The broker will sit down with you and go over the contract and guide you through the process. The broker will discuss the down payment options, the best lenders for the transaction if you are using SBA financing, and Stock vs. Asset sale, transaction structure and timeline.  We highly recommend using an industry standard Purchase Offer such as the California Association of Business Brokers (CABB) Asset Purchase Agreement or Stock Purchase Agreement.  
  8. Broker Presents Offer:
    When you have completed and signed the Purchase Agreement your broker will present the offer to the seller.  If the Seller sends a Counter Offer the broker will review it with you.  Note that with the offer you will provide the broker with an Earnest Money deposit.  This deposit is usually held uncashed until you have removed your Due Diligence contingency in writing at which time the deposit will be sent to escrow to formally open escrow.  
  9. Offer Accepted, Due Diligence Starts:
    Once the offer is accepted by both parties Due Diligence starts.  You will be asked to provide a due diligence list of the information you wish to review.  This typically includes bank statements, 3 years of tax returns, employee info, etc.  Due Diligence typically takes 2 to  weeks once you have received the information and the timeline is specified in your offer.  On small businesses it is common for the buyer to do their own Due Diligence review.  In some cases buyers may elect to have a CPA assist them with the financial review and on stock sales or larger transactions buyers sometimes also engage an attorney to advise them.  Regardless of if you engage professional advisors or not, at the end of the day, it is your decision to buy the business or not.  We highly recommend buyers to be directly involved in Due Diligence and not to solely rely on advisors.  
  10. Due Diligence Complete & Escrow Opens:
    When you are satisfied with due diligence escrow is opened and your broker will provide you with a closing checklist in addition to the closing checklist from the bank and escrow.  If you are using SBA financing the bank will have a long list of documentation required and lots of paperwork.  We recommend starting the SBA application as soon as possible as this is the longest lead time item.  
  11. Escrow Closes:
    Once your loan is approved and everything escrow needs is completed the transaction closes and you now own your own business.
  12. Training Starts:
    Training starts after the close of escrow.  Your Purchase Agreement will have a training period specific with a number of weeks and hours per week that are included in the purchase price.  This is  typically 4 weeks, sometimes up to 6 or even 8 weeks.  This is negotiable but keep in mind that Sellers do not want to provide extended training for free, especially if the price was less than full price.  A consulting agreement is often included in the Purchase Agreement for extended training at a specified price. 
  13. Transition: 
    During and after training remember you have bought a business that has been successfully operating for perhaps 20 or 30 years.  We recommend avoiding the temptation to immediately start “fixing” or improving things as the new owner or boss.  Remember there is likely a lot of loyalty to the old owner and employees know the current systems.  Often there are reasons for the way things are done that you may not immediately understand.  Learn the business from the owner, be patient, and only implement changes after you thoroughly understand the entire business from front to back.  

For more about how to buy a business preview my book, “Own your Future, Straight Talk about Buying a Business and Building Your Future.” 

Additional Information

FAQs Buying a Business

How to Value a Small Business

What Questions Should I ask the Seller About Their Business?

What are Discretionary Earnings? 

The Other Side of COVID-19, How Do I Sell My Business after a Pandemic?

Category: Business Valuation Selling Your Business 

COVID19 has clearly thrown a wrench into the plans of business owners that were preparing to sell their business, or has it?  

Businesses that were forced to shut down during the Stay Home or Shelter in Place orders may find it  necessary to either postpone the sale or reduce the price of your business based on the current market conditions.  However, businesses that have been able to continue to operate such as essential service providers will be in high demand during and after the pandemic is over.  Likewise, businesses that are able to recover quickly after being forced to shutdown or slowdown during the pandemic will also be in demand as our economy recovers.  

What will be the impact of COVID-19 on Business Values and Marketability? 

Business sales/transactions have plummeted during the pandemic because many sellers have pulled their businesses from the market or decided to wait until the pandemic passes to put their business on the market.  Likewise, many buyers are now on the sidelines waiting for this to pass and businesses to be broadly open again before they are comfortable with the economic climate and the general health and safety risks associated with the pandemic .  With that being said, Pacific Business Sales has had several offers on businesses we represent and several transactions in escrow during the pandemic. These are businesses that have been able to continue operating because they are essential services or e-commerce businesses.  

Of course the larger question is what will happen once the Stay at Home orders are lifted and businesses are open again?  

Business Values after COVID-19

Businesses are valued based on cash flow, more specifically Discretionary Earnings (DE) and a multiple is applied to the DE.  Valuation multiples are based on the size of the business and it’s industry, these multiples do not change much over time or with the economy.  For example the multiples in previous economic down turns remained relatively the same, including during 2008. Business values do drop as a result of an economic downturn due to a drop in Discretionary Earnings.  

What will determine the value of your business after the pandemic is over is the DE the business is generating at that time.  Post COVID-19 valuations can take into account the economic impact of the pandemic by normalizing the company’s revenue and earnings during that period.  Below we discuss how businesses will be valued going forward and how revenue and earnings will be adjusted to account for the impact of COVID-19.  

SBA Financing and Valuations

We have spoken with our top SBA lenders about the impact of COVID-19 on business valuations and financing for the purchase of a business.  The lenders understand that many businesses will see a significant drop in sales during the pandemic and stay at home orders. Underwriting guidelines will be modified to account for this event and to normalize the company’s revenue and earnings.  

The approach bank underwriters and business appraisers (valuation analysts) will be using is as follows.  Revenue and earnings during the pandemic and until the Stay at Home Order is lifted will be removed and replaced with average sales and earnings figures from the previous year or perhaps a 3 year average.  This will normalize the revenue and earnings to remove this catastrophic event from the revenue, earnings and valuation.  

Preparing Your Business for Sale After COVID-19

If your business was not affected by the Stay at Home orders and COVID-19 then preparing your business for sale will follow the normal steps.  If your business was shut down or had a substantial slowdown there will be additional action to take. We have outlined the Post COVID-19 steps to prepare your business for sale below.  

Preparing to Sell Your Business after COVID-19 Pandemic & Stay at Home Orders 

  1. Recovery & Stability:
    As businesses open and recover the key thing buyers and SBA lenders will be looking for is financial recovery and stability.  No one expects any business to recover instantly, but they will be looking for solid indications the business is recovering and getting back on track.  Obviously you have a huge motivation to do this as quickly as possible regardless of the prospective sale, but this is also a factor in selling the business.

  2. Financial Books & Records:
    Books and records are always important in the sale of a business and post pandemic they will be even more important.  It is vital that you have good books and records showing the costs associated with the shut down or slow down as well as documentation of any one time costs related to the pandemic.  It will be important to have your 2019 Tax Return prepared and ready to file plus all of your financial records in order for the past 3 years to prove revenue and expenses that correlate to the same timeframe as the COVID-19 timeframe.

    For companies that continued to operate during the Stay at Home orders it will be important to document any extraordinary expenses during that time and document the sales and earnings during that time as well as afterward. 

    After businesses reopen it will be important to have good books and records showing your recovery, new orders, revenue, customers, earnings and actions taken to recover. 

  3. Operations & Infrastructure:
    Infrastructure is a major selling point with buyers.  It doesn’t necessarily directly add value, but it definitely makes a business more marketable and sell more quickly. 

    If your business is shut down or has slowed down now is a great time to work on systems and procedures, get organized and improve your infrastructure.  

  4. Marketing:
    As with infrastructure, having a marketing program in place does not directly add value, but it does make the business more attractive to buyers.  Likewise, a good marketing program should improve your sales and speed the recovery of your business which will increase the value of the company.

  5. Customer Concentration & Stability:
    Customer concentration and stability is always important to both buyers and lenders.  During the recovery customer retention will be key. Of course many of your customers will be recovering too and of course this is expected and understandable.  The key thing will be able to show the customers have been retained.

  6. Staff:
    Staff is also always important to buyers, and conversely businesses that are heavily reliant on the owner are very difficult to sell, often selling at discounts.  If you have staff it will be important to ensure they return to work when your business reopens. If you are shut down or have slowed down now is a great time to think about how you can improve your staff, how to delegate more of your work, and build a better team.  Businesses with a solid staff and that are less reliant on the owner are much more marketable.  

Selling a Distressed Business During COVID-19

If your business is distressed because of COVID-19 and the Stay at Home orders it can still be sold.  Distressed businesses sell at very steep discounts, often for the value of the assets, but they can be sold even during this time.  

Information Required for a Distress Sale

  1. General business information: 
    1. business name, address, corporation name
    2. Type of business
    3. Years established
    4. Building square footage and type
    5. Number of employees
    6. Equipment list (we will send this to you)

  2. Financial Statements
    Note if the business is closed and this will be an asset liquidation sale the information below is not required.  If the business is open or likely to reopen the information below will be required. 
    1. 2020 P&L by Month 
    2. Last 3 years Tax Returns (Federal only) 
    3. Last 3 years P&Ls 

INFORMATION ON BUYING-SELLING A BUSINESS

 

How to Value a Small Business Using Earnings Multiples

Category: Business Valuation Buying a Business Selling Your Business 
A business owner or prospective seller may want to know the value of their business before deciding to put it on the market.  Buyers may wish to calculate the value or compare the asking price of a business they are interested in. In the case of business owners considering the sale of their business most business brokers offer a free Market Value Analysis and in fact our firm offers a comprehensive Business Market Value Analysis to prospective sellers.  In either case, the simplest method to obtain an approximate business value is to use the Earnings Multiple method (also known as Market Data, Comps, Discretionary Earnings  or DE Multiple).

Most business buyers and sellers/owners are somewhat aware of earnings multiples but few understand how to properly use and apply these multiples to value a business.  There are many myths and opinions about what a business is worth and what “the” earnings multiple is.  In fact earnings multiples vary widely by industry as well as by earnings.  There are different multiples for Discretionary Earnings (DE aka SDE or Seller’s Discretionary Earnings) and EBITDA (Earnings Before Interest Taxes Depreciation & Amortization).  DE multiples are lower than EBITDA multiples because with DE you are multiplying a higher earnings number against a lower multiple and with EBITDA you are multiplying a lower earnings number against a higher multiple.  Ideally you should get roughly the same value for both approaches. There are no valuation multiples for “net profit” for a small-midsize business and simply applying say a DE multiple to Net Profit will result in a dramatically undervalued figure for the business.  As explained below, the Net Profit does not reflect the actual earnings of a small business, thus using it for valuation purposes is meaningless.

While Earning Multiples seem like a simple method to value a business, and they can be, they must be used correctly and on the right earnings value to deliver the correct valuation for a business.  

Discretionary Earnings vs Net Profit vs EBITDA

First you need to understand the difference between each earnings type and how to calculate them, then look at how to apply them.  

  • Net Profit:
    This is the starting point for calculating both DE and EBITDA.  When a business broker or valuation analyst refers to Net Profit this is the Net Profit shown on the company tax returns.  The Net Profit on the company P&L is often different from the Tax Return Net Profit as a result of changes made by the accountant or CPA at year end which were not reconciled with the P&L.  The Tax Return Net Profit is the only figure used for valuation purposes (note that SBA lenders and valuation analysts only use the Tax Return Net Profit).
  • EBITDA:
    EBITDA is actually simple to calculate.  Start with the Net Profit from the Tax Return and add the Interest, Taxes, Depreciation, & Amortization.  This is the non-normalized EBITDA and for very large businesses this figure is correct. For small businesses we must subtract a replacement salary for the owner at market rate.  This would be the salary of a manager to run the business in
    place of the seller.  This is called Normalized EBITDA which is used for small businesses.  
  • Discretionary Earnings (DE):
    DE is the most commonly used valuation multiple and it is also the most complicated figure to calculate.  DE basically is EBITDA + owners salary + owner’s benefits & expenses. This sounds simple enough and it would be except that many owners bury these expenses which can make it difficult to verify these figures.  One key rule for owner’s expense add backs is that they MUST be tied to an expense line item on the tax return. If the expense is not shown on the tax return then it cannot be used as an add back for calculating DE as it was not shown as an expense on the tax return, which is what is used to calculate DE.  

Finding the Right Earnings Multiple for a Business

You can get Discretionary Earnings multiples and Business Valuation Reports from BizBuySell and Peercomps.  BizBuySell offers valuation reports from $19.95 to $59.95 and Peercomps offers a one time comps search for $49 or a one time business valuation for $99.  

The BizBuySell valuation is the simplest to use and the least expensive.  While it is good for determining a price range, the downside is that it is not an accurate valuation program.  You should only use it for validating a price range and not for determining an exact business value. Note that the comparable sales data in BizBuySell is broker provided, meaning that brokers input this data when a business is sold through BizBuySell.  There are thousands of transactions in the database, the problem is that the way brokers record transactions can vary, making the data less consistent than Peercomps.

The Peercomps valuation is more comprehensive and uses better comparable sales data as their database is from actual closed SBA financed transactions.  All SBA loans require an independent (third party) business valuation (appraisal) by a CVA (Certified Business Valuation Analyst). Thus this comparable sales data is more accurate and more consistent than broker provided comps.  The downside of Peercomps is that it is much more complicated to use and obtain an accurate valuation. The user should be familiar with valuation methods in order to use Peercomps.

Steps to Finding Earnings Multiple Comparable Sales Data

  1. In BizBuySell or Peercomps select the Industry-Business Type (e.g. Distribution, Restaurant, Manufacturing, Construction – note that you can select more specific business types)
  2. Narrow the Gross Sales and Income ranges to values below and above the company’s annual revenue and income.  Set a minimum value to eliminate businesses much smaller than the company you are considering and a maximum to eliminate businesses that are much larger.   
  3. You can change the ranges to narrow or expand your results until you have a suitable number of comps (preferably at least 5 to 10 or more.  In some cases there may be very few if it is a small niche).
  4. Now you should have comparable sales multiples for Discretionary Earnings and if you used Peercomps Normalized EBITDA as well.  The next step is to apply the multiples

Important Notes:

  1. Most DE multiples do not include inventory or A/R (Accounts Receivable) and also assume that all liabilities are paid off by the Seller at closing.  
  2. Peercomps multiples include “normal” inventory and BizBuySell comps may or may not.
  3. Normal inventory is the inventory required to operate the business.  Excess inventory is not included in the earnings multiple.

Applying the Earnings Multiple to Determine Business Value

If you are using the valuation report from BizBuySell or Peercomps you can input the company earnings and revenue to obtain a value based on the Mean or Average Discretionary Earnings multiple.  If you elected to obtain comparable sales data only your next step is to multiply the Mean or Average DE multiple to the DE you calculated. This will give you a value based on the Mean or Average multiple.  

It is important to note and understand that the figure you just calculated is not an exact figure.  The multiple you just used is an average.  Thus, half of the businesses in the comps sold for less than that multiple and conversely half sold for more than that figure.  

If you are considering a business that is exceptional it may be worth a premium and the average multiple may be on the low side.  Likewise, if the business is below average it may be appropriate to apply a discount.

7 Factors that Affect Business Value and Earnings Multiples

  1. Quality of Financial Data
  2. Quality of Product or Service
  3. Competition
  4. Years Established
  5. Quality & Experience of Staff
  6. Infrastructure, Systems, Procedures
  7. Customer Concentration

Earnings Multiples are a convenient and relatively simple way to calculate business values, but as we discussed above, it is not an exact value and more of an average value.  If you are buying a business the Business Broker should have a Recast Financial Statement showing the financials from the Seller’s tax returns and all of the add backs to arrive at the Discretionary Earnings.  The Broker should also be able to provide you with Comps Data and a Market Value Analysis.

If you are Selling your business we recast your financial statements and prepare a comprehensive Market Value Analysis as part of our initial review of the business to determine the asking price.  

INFORMATION ON BUYING-SELLING A BUSINESS

How to Determine the Value of a Business

Category: Business Valuation Buying a Business Selling Your Business 
What is the value of my business?  This is the first and foremost question on the mind of business buyers and sellers. Business owners that are either considering selling their business or preparing to sell their business need to know what a realistic market value is for their business. Buyers face the same question when they are searching for and considering businesses for sale; what is this business actually worth? Below we explain what a formal Business Valuation is, Market Value Reports, and how to obtain a good estimate of the market value of a business on your own.

Business market values are not as simple as residential real estate where you can go to Zillow or other websites and quickly see what similar homes in the area are selling for. First there are many different types of businesses-industries, and each is valued very differently. Secondly, business values are driven by earnings, so even businesses in the same industry will have very different values depending on their earnings.

Businesses are actually valued by very specific methodologies and there are a number of industry certifications for analysts trained and certified in Business Valuation. The most common professional designations for valuation analysts are CVA (Certified Valuation Analyst), ASA (Accredited Senior Appraiser), CBA (Certified Business Appraiser), and ABV (Accredited in Business Valuation). Many professional Business Brokers have had formal training in business valuation from organizations like CABB (California Association of Business Brokers) or the IBBA (International Business Broker Association) which offer a number of classes in recasting financial statements and business valuation.

A formal third party Business Valuation typically ranges from $2,500 to over $5,000 or even $10,000 depending on the purpose of the valuation. For example valuations for divorces or related to litigation are much more extensive and hence more expensive. Basic third party valuations for smaller businesses can be obtained for around $1,750. Most professional Business Brokers, including our firm, offer free Market Value Reports.

So what’s the difference between a “Market Value Report” and a formal third party  valuation? Many Market Value Reports are very basic and do not include an in depth review of the businesses financial statements. At Pacific Business Sales our Market Value Report is comprehensive. We recast the last 3 years financial statements following CABB and IBBA guidelines, use Peercomps business valuation software to obtain relevant comparable sales data, and use the Peercomps valuation software to calculate an accurate Market Value based the Market Data Approach (comps) and the Income Approach (discounted future cash flow model). This results in an accurate data driven business value.

A Simple Method to Determine the Value of a Business on Your Own

The simplest way to value a business is the Comparable Sales Method, also known as “comps”. Comparable Sales databases provide average sales values based on the industry type with average multiples of Discretionary Earnings,  revenue, and in some databases EBITDA (Earnings Before Interest Depreciation Taxes & Amortization). Chapter 11 of my book, “Own Your Future” explains how to value to a business with examples of using comps to estimate business values.

The concept for using comps is simple, select a similar industry, then select companies with similar revenue and earnings and use the earnings multiples to determine the value of your company. The obvious question is where do I get comps?

Business Brokers and analysts have access to professional databases that are not available to the public.  However, you can access a database of both for sale and sold Comps and run a basic valuation through BizBuySell.com for $19.95 to $59.95. While this is not a formal business valuation, it is a good tool for estimating the market value of a business and it is very simple to use. The BizBuySell.com business valuation tool is easy to use and also easy to obtain erroneous results as the database is not as accurate as others because while the data is from closed transactions it is broker provided figures.

BizBuySell Business Valuation Report
Peercomps offers a more comprehensive valuation tool which is used by business brokers and valuation analysts. The Peercomps database is from actual closed SBA financed transactions and the valuation data is from the actual independent business valuation prepared by a Certified Valuation Analyst. You can obtain a free comps report for your industry and a complete do it yourself valuation report for $99. This is a great deal for a valuation, but it is fairly complicated.

Peercomps Business Valuation - Comps

Steps to Calculate the Market Value of a Business

To get an accurate market value you must use the correct value for the company’s Discretionary Earnings and revenue. While revenue figures are easy to obtain, calculating the correct Discretionary Earnings is more complicated (see What is DE for more information). Simply put, Discretionary Earnings are the total economic benefit of owning the business. This includes the owner’s salary, health and life insurance, and other owner’s benefits such as travel & entertainment, auto expenses, and other personal expenses.

To calculate the DE start with the net profit on the tax returns and then add back the owner’s salary and benefits. It is important to ensure that all expenses are shown on the tax return (some may be shown on expense statements on the tax return or buried in general category). Expenses that are not tied to a line item on the tax return should not be added back.

  1. Tax Returns: You’ll need to have the last 3 years or Federal Tax Returns to calculate the DE for Peercomps. For a rough estimate you can use an estimated DE but remember, a small error on the DE will result in a big error on the estimated market value since this is multiplied by the DE Multiple.
  2. Calculate the DE (Discretionary Earnings).
  3. Comps: look up comparable sales for businesses in the same industry with similar revenue and earnings. It is very important that the industry, revenue and earnings are all similar to get reliable comparable sales figures and multiples. When selecting the comparable sales to use, remove any that have much higher or lower earnings than the company you are considering and use comps from businesses that are as close as possible to the company you are evaluating. Preferably you should have at least 5 or more comps.
  4. Apply DE and EBITDA Multiples: Use the DE and EBITDA multiples from your comps to multiply against the DE and EBITDA for the company you are considering.

For a Free Market Valuation of your business Contact Us.

Get Your Free Business Valuation Now

How Much Money Does a Small Business Make? What are Discretionary Earnings (DE)?

Category: Business Valuation Buying a Business Selling Your Business 
The burning question for buyers looking at prospective small businesses is “how much does this business make?”. This is actually the wrong question. The right question is how much does the owner make? One of the first steps in preparing to sell a business for a professional business broker is determining the Discretionary Earnings of the company.

If you just look at the net profit shown on the business tax returns for most small and midsize businesses it looks like they don’t make much money. What you are missing is the owner’s salary, benefits, and expenses that are run through the business in order to minimize their taxes. These expenses include the owner’s salary, 401K or other type of retirement plan, health and life insurance, auto expenses, travel and entertainment, etc. These expenses can be a significant amount of money, consequently the Discretionary Earnings for a business are always substantially higher than the net profit shown on the business tax returns.

One of the first questions to address is which financial statement to use, the P&L statement or tax returns? The Federal Tax returns are always used for business valuation purposes. The P&Ls are used for expense details and supporting documentation, but the tax returns are treated as the official and final financial statement for the business.

Adding Back Owner Benefits & Expenses (Addbacks)

What is a legitimate owner benefit-expense addback? The simple answer is any expense that is not a necessity for business operations. There is however a caveat to this, in order for an expense to be a legitimate addback it must also be shown on the business tax returns as an expense line item or be part of an expense line item. Expenses not shown on the tax return (e.g. on the P&L or claimed by the owner) would not be added back because these expenses are not being deducted from the business gross margin as an expense. In other words, these expenses didn’t happen from a tax return standpoint.

In addition to owner benefits and expenses there are other addbacks to calculate the DE for a business. These are Depreciation, Amortization, Interest and Taxes. These expense items aren’t “owner benefits” so why would these be added back? While Depreciation and Amortization are not actual owner expenses, they are what is called a “non-cash” expense. There were no checks or actual payments made to Depreciation or Amortization and in fact many small business P&Ls don’t show these expenses. These expenses are added to the tax return by the CPA to write off capital expenses like vehicles, equipment, franchise agreements, and other asset purchases over the life of the asset. For example, a vehicle purchased for $50,000 might be expensed through depreciation over 5 years resulting in a $10,000 per year depreciation expense.

Interest is clearly an actual business expense so why is that added back? While the current owner may have interest expense in the business, it will certainly be very different from the interest expense the buyer will have. So the DE calculation adds back interest to arrive at the business earnings with zero debt and the buyer can subtract their expected debt service (expense) from the DE to arrive at a net after debt service figure for the business.

Banks use this same methodology to calculate the net after debt service earnings of a business for SBA financing.

Common Owner-Seller Addbacks to Calculate DE (Discretionary Earnings)

Below are the common expenses added back to the tax return net profit to arrive at the DE for business.

  1. Interest Expenses (see explanation above)
  2. Depreciation (see explanation above)
  3. Amortization (see explanation above)
  4. Officer’s Salary (if it is the owner’s salary)
  5. Family member salary-wages
  6. Health & Life Insurance (owners)
  7. Pension & 401K (owners)
  8. Travel & Entertainment (if not business essential)
  9. Auto Expenses (owner’s personal vehicles)
  10. Other Common Expenses where Owners may have Expenses:
    1. Office Supplies
    2. COGS (Cost of Goods Sold) – some owners run expenses through this category. While the expenses may be valid, many banks question expenses in this category and you will need receipts that clearly show these are non-business expenses.
    3. Misccelaneous Expenses
    4. Utilities
    5. Legal & Professional

What’s the Difference Between EBITDA and DE?

EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) is a common financial term and more commonly known than DE. EBITDA is most commonly used for businesses with at least $5 million to $10 million in sales and above. While it is a good metric for larger businesses, it does not include add backs for owner’s benefits which can be substantial. Thus, if EBITDA is used for a small business the figure would be significantly understated which is why DE is the preferred earnings figure for small businesses.

EBITDA is used on mid-sized businesses in some cases such as when the business is managed by a full time manager. If you use EBITDA to calculate the value of a small business you add back any owner salaries and benefits. This is referred to as an Adjusted EBITDA by valuation analysts.

Working with a Business Broker

When a buyer is looking at businesses for sale the business broker will have prepared a Confidential Business Review which will include a calculation of the Discretionary Earnings based on the Seller’s tax returns and stated owner’s benefits and expenses. After your offer is accepted you will have the opportunity to verify the DE by reviewing the Seller’s tax returns, expenses, bank statements, invoices, etc during Due Diligence.

Selling Your Business & Business Valuation Seminar Scams

Category: Business Valuation Selling Your Business 
It starts with an invitation to a “free” seminar about Selling Your Business or the Value of Your Business. Of course you think, why not. When you arrive there’s a number of young MBAs in suits and a couple of more senior people that will be presenting. The presentation is polished and professional, it sounds good, and is very convincing. As the pitch goes, they have a huge pool of buyers looking for businesses just like yours.

Then there’s the catch… In order to sell your business they need a business valuation and/or a prospectus-marketing package that costs between $5,000 to $20,000 or more. They confidentiality throw out a valuation figure, much higher than you expected, and the explanation is convincing. It all sounds great, wow, you never thought your business was worth that much!

Let’s break this down. First, the cost of a professional third party valuation is typically between $2,500 and $3,500 for most businesses. If it is a large company, a complex valuation or if it involves legal issues the cost can be substantially higher, but these are the exceptions. If you want a business valuation you should ensure the firm and individual preparing the valuation is a certified business valuation analyst. We work with several firms that specialize in business valuations and their staff are all certified analysts. Also, our firm as with most professional business brokers, offer a free Market Value Report as part of our services. If you want to know the market value of your business this will suffice. Our Business Market Value Report is based on comparable sales (comps) and cash flow based valuation methods and is very comprehensive.

Second, the marketing package. Our firm as with most professional business brokers do not charge an upfront fee or charge for the preparation of the marketing package. There are exceptions for large M&A transactions, but for most midsize businesses there is no upfront fee. Our fee is paid at closing when the business is sold.

Lastly, will they actually sell your business? Our experience from talking with business owners that have attended these seminars is no. One business owner told us he paid $20,000 and never had a buyer inquire. When he asked for his money back he got a list of buyers they claimed had inquired. Yes, he called the “prospective buyers”, none of them were what he considered real, but he never got his money back and that firm never sold his business.

These seminars have been around for decades under many different company names, but the scam is the same. The problem is these companies charge huge fees upfront regardless of whether they sell your business or not. In fact, the track record these firms have for actually selling businesses is very poor. Before you pay thousands of dollars upfront for a very risky proposition, contact us for a free Market Value Report and consultation.