When you decide to sell your business, the most important consideration in determining its market value is verifiable cash flow. Most small business buyers are leaving corporate America and their main goal is to replace the income stream they lost from their previous jobs. A small business acquisition (under $500k) can replace most people’s salary and offer a reasonable return on their invested capital.
What is Owner’s Discretionary Cash Flow (ODCF)? You may also have heard it called, Seller Discretionary Earnings, Owner Benefit, of Discretionary Earnings (DE). All of these mean the same thing, but the simplest definition is, “the amount of money a new owner would be able to take out of the business annually.”
What makes up ODCF? Some line items that make up ODCF are easy to identify, such as owner’s salary and net profit, but other items take a little more research.
Net Income + Owner Salary + Depreciation / Amortization + Interest + Nonrecurring/Normalized Expenses + Owner Perks = Owner Discretionary Cash Flow
Net Income
Income minus expenses equal your net income – simply stated, this is the profit of the business. Lenders and buyers will want to review 3-5 years of the seller’s tax returns to verify the net income. Accountant compiled tax returns are the holy grail when buying a small business. A tax return may show little or negative net income, but this does not mean the business does not produce cash flow. Tax preparers try to reduce their clients’ tax obligation by showing as little income on the tax return as possible; however, after a business intermediary performs a recast, the true ODCF is revealed.
Owner Salary
Any amount that an owner receives as payroll income is added back to the net income. This includes the payroll taxes the business paid for the owner’s payroll. If there are two working owners who want to exit the business, only one can be added back and the other should be adjusted to an appropriate wage to replace one of the outgoing owners. Adding back the owner’s salary is what makes ODCF slightly different from its much more talked-about cousin EBITDA, which is used more often in large business transactions.
Depreciation / Amortization
This non-cash expense shown on the tax return does not impact cash flow but helps reduce the owner’s tax liability. It is always acceptable to add this expense back to the net income of the business.
Interest Expense
Adding back any interest expense to the net income is almost always acceptable. Even though the buyer may also have to pay interest as the new owner, this will vary drastically from one person to another. Everyone will have different interest rates and terms, and some people don’t need to borrow any money at all. To keep this uniform, this expense is added back to the business net income.
Nonrecurring Expenses
Expenses that are not usual for the business can be added back to the net income. Examples include replacing an HVAC system, legal fees, or a large debt from a customer who defaulted in paying their bill. Looking back over a 5-year period, you will see the average expenditures per year. When one expenditure starts to increase or decrease drastically from the mean, it should be examined to determine if there was a nonrecurring expense that should be adjusted to the net income.
Likewise, unusual income such as an insurance payout, an unusually large sale, or unique environmental or economic situations that are not likely to repeat themselves should be reduced or normalized to what a new buyer could expect.
Owner Perks
One of the most advantageous benefits of owning a small business is the ability to have the business pay for certain personal expenses. Owner perks consist of expenses personal to the owner; therefore, none of those costs would necessarily be transferable to a new owner. Common examples include owner’s health insurance, retirement plans, personal vehicles, travel, meals and entertainment, county club dues, or inflated wages of working or non-working family members. It is important to remember that in order to add these perks back to the business net income, they must be documented and verifiable.
The recasting of the seller’s financial statements should be done for each of the last 5 years. A Certified Business Intermediary (CBI) can help with the recast to determine your ODCF as the first step in helping you discover the market value of the business.
If you need help in determining your business value, please contact us to learn how we can assist you.