Most businesses are valued based on a multiple of EBITDA or seller’s discretionary earnings plus inventory. There may be some other factors involved in the valuation such as current value of equipment, but this usually only comes into the valuation when it is a business with a substantial amount of equipment such as a heavy construction or manufacturing business. For this article we would like to focus just on EBITDA and seller’s discretionary earnings.
EBITDA and seller’s discretionary earnings are very similar, but seller’s discretionary earnings simply takes it one step further. Most people may know that EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Seller’s discretionary earnings is EBITDA plus owner’s salary and personal expenses or as we like to call it “non-business essential” expenses.
EBITDA is most often used when valuing mid-market business whereas seller’s discretionary earnings is used when valuing main street businesses. The reason for this is that most small main street business owners live through their business. By this I mean they may take business trips and stay a few extra days as a vacation or employ family members that they pay a salary significantly above the market average due simply to being family. There are also many non-business essential expenses they run through the company to minimize taxes that another potential owner would not incur. For what might be obvious reasons, we will not discuss these in this article.
Even though EBITDA is the most commonly used multiple factor for valuations of mid-market businesses there are a lot of times when seller’s discretionary earnings should be used instead. Let’s look at an example:
1. A restaurant has EBITDA of three million, the owner is semi-absentee (only looks at reports), pays herself a million dollars a year in salary and has travel expenses of $500,000. They do not cater nor offer delivery.
2. The same restaurant has EBITDA of three million a year, the owner is full-time active in the business, does not pay herself a salary, and only has minimal travel expenses of $5,000. They do not cater nor offer delivery.
Simply using EBITDA the value of these two businesses would be the same. However, we all know this does not make logical sense.
So what should be done to adjust the valuations of the two examples above? A business valuation expert would evaluate the market and determine how much it would cost to replace the current owner and why there was such a high travel expense in the first example when they do not cater or deliver. This is when you would use seller’s discretionary earnings as the multiple factor instead of just EBITDA.
If the current owner only looks at reports, such as in the first example, they would probably not need to be replaced and therefore, no employee expense. If they do not cater or deliver one would realize the vast majority of the $500K in travel is a non-business essential expense. In this case we would add back the million dollars in owner’s salary and usually 90% of travel expense to EBITDA so now the seller’s discretionary earnings is $4.45M.
In the second example where the owner does actively run the business one you would need to consider their duties and determine how much it would cost to hire an employee to perform these same duties. If it would cost $200,000 to replace the owner then you would subtract this from her current salary. However, in this case where the owner doesn't take a salary you would subtract the $200,000 from EBITDA. Since there was minimal travel expense there would be no need to adjust those numbers. Therefore, in the second example the seller's discretionary earnings would be $2.8M compared to the $4.45M in the first example.
These two businesses were valued the same when we simply use EBITDA. However, after digging in the business and financials a little deeper we realize there should be adjustments made. These adjustments show the first business should be valued higher than the second. No two businesses are exactly the same, but we do see a lot of situations like the one above where seller’s discretionary earnings should be used as the multiple factor for a mid-market business instead of just EBITDA.
EBITDA and seller’s discretionary earnings are very similar, but seller’s discretionary earnings simply takes it one step further. Most people may know that EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Seller’s discretionary earnings is EBITDA plus owner’s salary and personal expenses or as we like to call it “non-business essential” expenses.
EBITDA is most often used when valuing mid-market business whereas seller’s discretionary earnings is used when valuing main street businesses. The reason for this is that most small main street business owners live through their business. By this I mean they may take business trips and stay a few extra days as a vacation or employ family members that they pay a salary significantly above the market average due simply to being family. There are also many non-business essential expenses they run through the company to minimize taxes that another potential owner would not incur. For what might be obvious reasons, we will not discuss these in this article.
Even though EBITDA is the most commonly used multiple factor for valuations of mid-market businesses there are a lot of times when seller’s discretionary earnings should be used instead. Let’s look at an example:
1. A restaurant has EBITDA of three million, the owner is semi-absentee (only looks at reports), pays herself a million dollars a year in salary and has travel expenses of $500,000. They do not cater nor offer delivery.
2. The same restaurant has EBITDA of three million a year, the owner is full-time active in the business, does not pay herself a salary, and only has minimal travel expenses of $5,000. They do not cater nor offer delivery.
Simply using EBITDA the value of these two businesses would be the same. However, we all know this does not make logical sense.
So what should be done to adjust the valuations of the two examples above? A business valuation expert would evaluate the market and determine how much it would cost to replace the current owner and why there was such a high travel expense in the first example when they do not cater or deliver. This is when you would use seller’s discretionary earnings as the multiple factor instead of just EBITDA.
If the current owner only looks at reports, such as in the first example, they would probably not need to be replaced and therefore, no employee expense. If they do not cater or deliver one would realize the vast majority of the $500K in travel is a non-business essential expense. In this case we would add back the million dollars in owner’s salary and usually 90% of travel expense to EBITDA so now the seller’s discretionary earnings is $4.45M.
In the second example where the owner does actively run the business one you would need to consider their duties and determine how much it would cost to hire an employee to perform these same duties. If it would cost $200,000 to replace the owner then you would subtract this from her current salary. However, in this case where the owner doesn't take a salary you would subtract the $200,000 from EBITDA. Since there was minimal travel expense there would be no need to adjust those numbers. Therefore, in the second example the seller's discretionary earnings would be $2.8M compared to the $4.45M in the first example.
These two businesses were valued the same when we simply use EBITDA. However, after digging in the business and financials a little deeper we realize there should be adjustments made. These adjustments show the first business should be valued higher than the second. No two businesses are exactly the same, but we do see a lot of situations like the one above where seller’s discretionary earnings should be used as the multiple factor for a mid-market business instead of just EBITDA.
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