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. Note that all owner’s benefits and expenses must be shown as an expense line item on the company tax return. It need not be a separate line item, but the expense must be included in one of the expense line items on the corporate or company tax return.
Verifying these expenses is done during Due Diligence after an offer has been accepted.
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.
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 beneftits, while EBITDA does not and includes the cost of a paid manager. Consequently 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 a business are:
- SBA financing
- Seller Note
- Personal Financing sources such as HELOC or other lines of credit
SBA financing is typically used on transactions over $250,000 and very common on transactions over $1 million up to $5 million.
Seller Notes are often combined with an SBA loan to reduce the Buyer Down Payment. For example with SBA financing for 80% of the transaction value and a Seller Note for 10% of the transaction value, the Buyer Down Payment is just 10%.
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.
For more information see our pages on SBA Financing
The contingencies with nearly every transaction are 1) Due Diligence 2) Lease and 3) SBA Financing.
Some Purchase Agreements may have contingencies relating to Franchisor Approval, Licensing, and Stock Sales have a 30 day Attorney Review for both Buyer and Seller.
The key contingency on every offer is Due Diligence. After an offer has been accepted Due Diligence commences. This is where the Buyer verifies the revenue and income of the business and reviews the business records, documents, procedures, etc. This is the Buyer’s opportunity to confirm the veracity of the business.
Due Diligence typically included a review of the following:
- Last 3 years business tax returns
- Last 3 years P&Ls and Year to Date P&L
- Current Balance Sheet and Balance Sheet from most recent year end
- Bank Statements last 3 years (month by month)
- Review of Recast Financial Statements and Seller Expenses Added Back with the Seller
- A/R reports
- A/P reports
- Payroll reports, W2 reports, and 1099s
- Review of Contracts
- List of Customers and review of any customers exceeding more than 20% of annual sales
- Equipment List
- Review of Seller’s Insurance Policies and Workman’s Comp Policy
- Review of Seller Disclosure Statement with the Seller
- Corporate Documents (if a stock sale and sometimes requested in Asset Sales by Buyer’s Attorneys)
- Plus additional items specific to the business or industry or requested by the Buyer’s advisors
At Pacific Business Sales we use the CABB (California Association of Business Brokers) purchase agreements. CABB has standardized purchase agreements for both Asset Sales and Stock Sales along with Buyer and Seller Disclosures.
The CABB purchase agreements include provisions for Due Diligence, Non-Compete Agreements, Training and Representations & Warranties. The CABB purchase agreements have been in use for many years and were created by a team of attorneys and business brokers with many years of experience in business sale transactions.
See our Blog Why Use a Standardized Purchase Offer or LOI to Buy a Business vs a Custom Agreement for more information.