Main Street and Premier Main Street business values normally use SDE (Seller Discretionary Earnings) and an industry multiple range, the ‘Multiple’ in determining the likely sales price range for a sale to a third party. Far too often business owners believe that they can add back all personal expenses to the net income number which creates real problems when they are ready to sell. It’s critically important that you confidently understand what can be added back and what is likely to be discarded when a lender begins their valuation. Remember that the bank is the most risk-averse to any business sale transaction and even if you can fully document a personal expense, it does not mean that the lender will allow it. This is why the real professionals in the business brokerage industry consult with lenders prior to finalizing the value of a business and certainly prior to bringing the business to market.
Which expenses can be added back when determining SDE? Both Amortization and Depreciation, as non-cash expenses are always added back. Interest expense is added back as a new owner will have their own interest expense (think interest on the business acquisition loan). One owner wage and the company-paid payroll taxes associated with those wages are added back. If your spouse or partner will be exiting and their role will need to be filled once they depart you cannot add back their full compensation. You must determine the cost to replace them with someone who will perform their duties. For example, if your spouse is being paid $40,000 and the (fair market value wage) cost to replace them to perform those same duties is $40,000 then you cannot add back their wage. If they have been paid $90,000 and the cost to replace them would be $40,000 then it is reasonable to add back $50,000 into the SDE calculation. However, if they have been paid $20,000 but the cost to replace them is $60,000 then you will have a negative add back which will reduce SDE. Take a hard look at the role and responsibilities of your partner or other family member and make sure you understand how their pay matches up to the fair market value of replacing that role.
Other expenses which are customarily added back: One-time and Non-Recurring expenses (a recent $10,000 overhaul of a website for example), Rent adjustments where the current rent is less than in the prior 2-year period may be added back to prior year SDE determinations if it can be substantiated that in the prior years the rent paid was significantly more than the operations warranted.
Personal expenses as add backs are a slippery slope and ones that business owners assume can be added back. The Tax Code allows for many personal benefits to be deducted as expenses in the Main Street and Premier Main Street marketplace. However, lenders take a very critical view of these and much like an IRS audit, if you cannot substantiate that it was a true business expense the lender will simply remove it from the SDE calculation. More importantly the reduction in sale price, because of the multiple, will exceed the change in SDE. Quite simply this means that the $20,000 in personal expense you claimed (and did not pay tax on) will cost you between two and three times the expense in selling price. Yes, you can certainly convince a buyer that this expense could have dropped to the bottom line but be advised that the previously mentioned lender is likely to toss it from the SDE calculation and therefore the selling price determination. There is a saying in business brokerage which a savvy business owner should begin thinking about a couple of years in advance of a sale: ‘You can only steal it once’. You may enjoy the tax savings but be assured that when it comes time to sell, your assumption will diminish the final selling price of the business.
Business owners would be wise to understand how the value determination for a business sale really works a couple of years in advance of their exit. Waiting until you are ready to sell is far too late to affect the changes which will maximize the exit value.