What is Discretionary Earnings (DE)?

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 (must be W2) 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.

IMPORTANT NOTE: ALL added back owner’s expenses/benefits MUST be shown on the tax returns under an expense line item and verifiable.  If the expense is not shown on the tax return it cannot be added back and counted toward DE.

Distributions:  Note that Distributions or Dividends are NOT part of the owner’s salary or compensation.  This is a balance sheet transaction and is NOT an expense on the P&L.  Thus it cannot be added back as it is not a P&L expense.

DE is used in most valuation methods including 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.  EBITDA is essentially the earnings of the business if it is absentee owned with a manager running the day to day operations.

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.

For more information see our Blog: What is De and EBITDA?

How is a business valued, how is market value determined?

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 the most commonly used business valuation methodology to calculate 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.

See our Blog How to Value a Business Using Earnings Multiples for more information on calculating business value.

How are businesses for sale advertised and marketed?

Sellers often ask, “how do you find buyers?”.  We advertise on the major business for sale websites and we feature our advertised businesses so they appear at the top of the business for sale pages.

Of course, reaching thousands of buyers is only half the challenge, we need them to inquire about your business.  We create engaging ads for the businesses we advertise selling the strengths and benefits of owning that business.  The ads we create are general in nature and do not name or identify the location of the business but describe it in enough detail to generate interest and inquires.

We don’t solely rely on buyers finding our ads, we also send email blasts to targeted buyer lists.

Our Confidential Information Memorandums (CIM) are the marketing brochure and comprehensive prospectus for your company.  The CIM provides an overview of your business, services, pictures of your products/services, financial statements and information about the transaction closing process and structure.  Note that the CIM is ONLY sent to prospective buyers after they have signed an NDA and completed our Buyer Profile.

We also use our CRM database of over 3,500 active buyers to search for buyers that have inquired about businesses similar to yours and inform them of new businesses for sale.

How is the sale of a business financed?

The three primary sources of financing the sale of 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. 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 page Financing the Sale of my Business.

Confidentiality; how do you keep the sale of my business confidential?

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 Information Memorandum (prospectus) 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 personal and financial qualifications.

When is the best time to sell my business?

The best time to sell your business is when revenue and earnings are on an upward trend or 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 and sell more quickly.

See our blog “When to Sell, When NOT to Sell and When to Sell Anyway” for more information on the best time to sell your business.

What are the taxes associated with the sale of my business?

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.

See our blog Stock vs Asset Sale for information on the advantages and disadvantages of Stock Sales vs Asset Sales.

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.  Our tax planning CPAs have tax strategies that can defer up to 90% of the taxes at closing and often reduce taxes by as much as 30% tp 40%.

For more information see our blog How to Minimize Taxes on the Sale of My Business

How Long does it take to sell a business?

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 inquiries and sell faster (assuming they are priced competitively).

What are the typical Contingencies with the Sale of a Business?

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.

What is Due Diligence in the Sale of a Business?

Seller’s Due Diligence:

The CABB (California Association of Business Brokers) Purchase Agreement has provisions for both Buyer and Seller Due Diligence.  Due Diligence is a Contingency for both Buyer and Seller.

Buyer Due Diligence involves the buyers review of the company’s financial records,  equipment, inventory, etc.  It is a comprehensive review of your company’s operations and financials and a critical stage of the transaction process.

Seller Due Diligence usually involves a review of the Buyer’s financial wherewithal, credit score, bank pre-approval, and resume or bio.

What does a Buyer review in Due Diligence on the Sale of a Business?

Due Diligence is the most critical stage of the sale of your business.  This is where the buyer verifies the revenue, earnings, and overall veracity of your business.

To ensure a smooth Due Diligence it is important for your financial statements and tax returns to be well organized and your add backs (owner’s expenses/benefits) to be verifiable.

Buyer Due Diligence typically includes review the following:

  1. Last 3 years tax returns
  2. Last 3 years plus year to date bank statements
  3. Last 3 years plus year to date P&Ls
  4. Most recent month end Balance Sheet
  5. Review of customer invoices
  6. A/R aging report
  7. A/P aging report
  8. Payroll reports and W2s
  9. Review of contracts with customers if any
  10. Review of Workman’s Comp policy and claims if any
  11. Seller Disclosure Statement (part of the purchase offer)
  12. Review of Owner benefits and expenses claimed as add backs (note: these must be shown on the tax returns as an expense.  They need not be a separate line item, but the expense must be in the tax return)
  13. Review of employee files and records

It is equally important for your business to be organized.  During Due Diligence the buyer is verifying the financials but also confirming this is a business they can step in and run successfully, a business that can make a transition to a new owner.

Non Compete Agreement with the sale of a business

Every offer has a non-compete agreement as part of the purchase agreement.

The non-compete will specify that the owner/seller cannot compete with the buyer for typically 5 years within a specified distance or sometimes counties.  The non-compete may include family members if they have been involved in the business.

For manufacturing businesses the non-compete distance may be the entire United States if their customer base is nationwide.  For service businesses the non-compete distance is typically the service area the company has been covering.

7 Steps in Preparing to Sell Your Business

Here’s a summary of 7 Essential Steps to Prepare Your Business for sale.  See our blog for additional details.

  1. Financial Statements, Books & Records
    Make sure your tax returns and P&Ls are accurate and well organized.  Make sure owner’s salary and benefits are well documented.
  2. Operations & Infrastructure
    A business with good infrastructure and well organized operations is more marketable as buyers can see they can step in and take over easily.
  3. Marketing
    Many small businesses have no active marketing campaign and that’s OK if your sales are growing or steady.  Marketing helps grow your business and diversify your customer base so if you are have no marketing campaign adding one will add value if it increases revenue and earnings.
  4. Customer Concentration
    Some niche businesses have high customer concentrations.  We have successfully sold businesses with very high customer concentrations, however, if you can diversify your customer base it makes your business more marketable and it will sell more quickly.
  5. Staff
    Having a well trained staff is a definite plus because buyers see this as ensuring continuity and easing their transition.  If the business is highly dependent on the owner it is very difficult to sell.
  6. Work with an Experienced Business Broker
    We are happy to meet with you to help you prepare for the sale of your business.  Contact us to set up a meeting to discuss preparing to sell your business and the market value of your business.
  7. Tax Planning
    If you are planning and preparing for the sale of your business, tax planning should be part of your preparation.  We work with several CPAs that are experts in tax strategies for the sale of businesses.  Contact us to arrange a complimentary meeting with one of our CPA partners.