Discretionary Earnings or DE is the total economic benefit the owner derives from the business. This includes the owner’s salary, benefits, and personal expenses that are run through the business. DE is very important as it is used to determine the market value of the business.
To calculate DE start with the Net Profit shown on the business Tax Returns and then add back the owner’s salary and all benefits. While this may appear to be simple, finding and determining these add backs can be complicated. An experienced business broker can accurately recast the financial statements to calculate the correct DE for a business.
DE is used in most valuation methods including by SBA lenders. EBITDA (Earnings before Interest Taxes Depreciation and Amortization) is also used in valuations, the difference between the two is that DE includes the owner’s salary and EBITDA has a manager’s salary included in the company expenses. Thus valuation multiples for DE are lower than those for EBITA as the DE multiple is applied to a larger earnings figure and EBITDA multiples are applied to much lower earnings figures. The result is generally close if the earnings are calculated correctly.
The most common method for valuing a business is using a multiple of the company’s earnings. Two critical factors in determining an accurate value are using the correct earnings and the correct multiple.
Earnings drive and determine the value of a business and are used in the most commonly used business valuation methodologies to calculate the business value. The two principal earnings used are DE (Discretionary Earnings) and EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). The difference between these two is that DE includes the owner’s salary and EBITDA does not and includes the cost of a paid manager. DE is always a significantly higher figure than EBITDA.
Valuation multiples based on DE are much lower than those based on EBITDA as DE is a higher figure. While DE and EBITDA multiples are very different, they produce similar valuation results when used properly. Multiples also vary by industry as well as by company earnings and revenue. Thus it is best to obtain comparable sales (comps) for a business of a similar size in the same industry.
The three primary sources of financing for buying or the sale of a business are:
SBA financing is typically used on transactions over $250,000 and very common on transactions over $1 million. Seller Notes are often combined with an SBA loan to reduce the Buyer Down Payment. For example with SBA financing for 75% of the transaction value and a Seller Note for 10% of the transaction value, the Buyer Down Payment is just 15%. SBA financing also offers attractive terms of 10 years at prime plus 2.75%.
When SBA financing is not available the only alternative is a combination of cash plus a Seller Note.
Confidentiality of the prospective sale is a paramount concern to business owners. All of our ads are blind ads with general-broad descriptions of the business, services, and products. No specific location is provided in the ads and only a general area such as Orange County or Southern California is provided in the ads. Buyers receive our Confidential Business Profile of the business after they have completed our Confidentiality Agreement and Buyer Profile. The Buyer Profile requires the buyer to provide a personal financial statement and background information so we can review their financial qualifications.
The best time to sell your business is when revenue and earnings are on an upward trend or at a minimum stable. It is possible to sell a business with declining sales, but the market value suffers and it takes longer to sell in this situation. Businesses with strong earnings and revenue growth fetch a premium.
The tax liability depends on the type of transaction, a stock sale or an asset sale, as well as a number of factors related to how your CPA has done tax planning. It is critical to discuss tax planning with your tax advisor prior to selling your business as some tax strategies need to be set up well in advance. We work with several tax strategy CPAs that can work with you to dramatically reduce your tax liability.
The length of time to sell a business depends on several factors. The asking price is a key factor in that if a business is priced at a premium, above market value, it will take much longer to sell as it will receive far few inquiries than businesses that are competitively priced. The industry is also a factor in the time required to sell a business. Manufacturing, distribution, and B2B services tend to have more inquiries than retail. Another factor is earnings, businesses earning over $250,000 are in more demand than businesses earning less than $100,000 and tend have more inquires and sell faster (assuming they are priced competitively).
Purchase offers included always include a Non-Compete Agreement for the Seller and any family members working in the business. Most Buyers want a 5 year Non-Compete Agreement, in some cases a 3 year agreement will suffice and is acceptable to the Buyer. The Non-Compete Agreement also has a geographic term usually in miles, cities or counties where the business operates.
In some instances such as retail businesses the geographic term may be very limited such as 15 to 25 miles. On the contrary with manufacturing or distribution businesses the geographic term may be for an entire county, state or even the US depending on the service area for the business.