Buying a Business FAQs

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 EBITDA 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.

Read more on our blog: What is DE and EBITDA

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 benefits, 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.

See our Blog How to Calculate Business Values using Earnings Multiples.

Determining how much “cash” you need to successfully operate your newly acquired business is one of the most difficult calculations in the acquisition of a small business. The classic Working Capital calculation is little help because it is simply current Assets less current Liabilities and does not consider A/R payment cycles, your new debt service for you SBA loan, and your own income requirements.

The Working Capital & Deal Check work sheet is designed to help you calculate how much post closing cash you need to have on hand to A/R payment cycles, your income needs, SBA loan payments, and also takes into consideration the working capital and line of credit (if any) included in your financing.

Access & use the Working Capital & Deal Check Worksheet 

The three primary sources of financing for buying a business are:

1. SBA financing
2. Seller Note
3. 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 3.0%.

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 typically have a 30 to 45 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:

1. Last 3 years business tax returns
2. Last 3 years P&Ls and Year to Date P&L
3. Current Balance Sheet and Balance Sheet from most recent year end
4. Bank Statements last 3 years (month by month)
5. Review of Recast Financial Statements and Seller Expenses Added Back with the Seller
6. A/R reports
7. A/P reports
8. Payroll reports, W2 reports, and 1099s
9. Review of Contracts
10. Invoices
11. List of Customers and review of any customers exceeding more than 20% of annual sales
12. Equipment List
13. Inventory
14. Review of Seller’s Insurance Policies and Workman’s Comp Policy
15. Lease
16. Licenses
17. Review of Seller Disclosure Statement with the Seller
18. Corporate Documents (if a stock sale and sometimes requested in Asset Sales by Buyer’s Attorneys)
19. Plus additional items specific to the business or industry or requested by the Buyer’s advisors

QofE (Quality of Earnings) is a deep dive into the financials of the acquisition target company by the Buyer’s CPA firm. QofE is the financial due diligence aspect of larger transactions and is routinely part of transactions with equity groups and institutional investors. These can often take 90+ days. A full QofE is common on transactions over $5 million in value.

In recent years QofE light has become more common on small and mid-sized transactions under $5 million in value. The QofE light reviews are simplified versions of a full QofE taking less time and costing much less money. QofE light reviews typically take 30 to 45 days, vs 90 days or more for a full QofE on a larger transaction.

Pacific Business Sales works with a third party CPA firm that will prepare a QofE light review for under $10,000, in 30 to 45 days.

Read more about QofE (Quality of Earnings) 

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.

While AI tools such as ChatGPT and Gemini will spit out an LOI as answer to a query, it will not likely be a good LOI to use for the purchase of a business. The AI response will depend on the query you enter and how specific you are about the transaction.  While the AI response may look sufficient, it will likely be missing key deal points, conditions, and terms for your particular transaction.

We recommend using an LOI or purchase agreement prepared by a professional business broker or your attorney for the specific transaction and terms you are proposing.

Pacific Business Sales uses the CABB (California Association of Business Brokers) LOI and Purchase Agreement forms which are well known and widely accepted industry standard forms.