20 Apr Owner’s Responsibilities
Written by: John Milnes, CVA
(4-6 minute read)
To understand how an owner’s involvement in a business affects its value, one must first understand how the company being valued is operated. Therefore, one should begin with asking the following questions:
- How many owners are there?
- How many hours per week do they work?
- What are their responsibilities?
The responses to the questions above will assist the appraiser in determining the levels of owner involvement, which include, but are not limited to, the owner being absentee, the owner operating the business on a full-time (or part-time) basis, or even multiple full-time owner-operators. These scenarios will be discussed in further detail below to explain how an appraiser should adjust the business’s discretionary cash flow, specifically Seller’s Discretionary Earnings (SDE).
Here are two important definitions to remember throughout this newsletter:
EBITDA = Earnings (Net Income) + Interest + Taxes (Corporate) + Depreciation + Amortization
SDE = EBITDA + Single Owner’s Compensation + Normalizing Adjustments
It is important to keep in mind small business valuations often rely on SDE, which always assumes a full-time hypothetical owner operator (regardless of how an actual owner or buyer chooses to operate the subject business). Therefore, this newsletter will focus solely on SDE.
Identifying Owners’ Wages
Before making any adjustments, the appraiser should determine if the current owner(s) is receiving a salary. Owners’ salaries are typically reported in the form of Officer Compensation (Form 1125-E on the Federal Tax Returns for an S or C Corporation), Guaranteed Payments to Partners (Limited Liability Company), or Management Fees. However, if the owner’s salary is not clearly identified on the income statements provided, additional documentation, such as a W2, 1099 or wage statement, should be requested.
Scenario 1: Owner is absentee (or has minimal responsibilities)
If the current owner is not involved (or has limited responsibilities) in the operations of the business, the company’s cash flow should be adjusted to reflect this. Assuming that the current owner is paying a manager or key employee to operate the business, this individual’s salary (plus related payroll taxes and benefits, if applicable) is added back to the company’s cash flow, as one hypothetical buyer can replace the responsibilities of both the manager running the business and the absentee owner.
If the owner’s daily responsibilities would need to be replaced in some manner, the appraiser can either treat the situation as a full-time owner operator (as discussed below), or make a partial salaries and wages adjustment – adding back officer’s compensation and the general manager’s salary, and further deducting a part-time salary accounting for a replacement for responsibilities a hypothetical buyer cannot absorb.
Scenario 2: Current owner operates the business on a full-time basis
If the subject company has one owner that operates the business on a full-time basis, then the owner’s compensation reported on the company’s actual financial statements should be added back to the company’s cash flow:
The Appraiser would deem that one hypothetical buyer would be able to replace the current owner operating the business, therefore, no further adjustments would be necessary.
Scenario 3: Multiple owners
In this example, a business has three owners that are each operating the business full-time, and it is deemed that a hypothetical buyer would be able to replace one of the current owners and would be required to hire two replacements for the other owners. As shown in the illustration below, Owner A is responsible for operations management, Owner B primarily works as a bookkeeper and Owner C is the shop manager. Therefore, a hypothetical buyer would replace owner A, and would need to replace the responsibilities held by Owner B and Owner C. In this situation, the appraiser should find a fair market replacement salary for each of the current owners’ responsibilities. Each of the owners’ salaries would be added back into the company’s cash flow and two fair market replacement salaries would be deducted from the company’s cash flow.
Keep in mind, if there are additional owners that do not work or are simply investors, no adjustment is required for these individuals. Additionally, if the second or third owner is working part-time, and the appraiser deems it to be reasonable, the appraiser could add back each of the owners’ salaries, and the fair market replacement salary for the additional owner could be adjusted to reflect part-time hours.
Conclusion
The main purpose of adjusting for owner’s responsibilities in a business valuation under a Fair Market Value standard of value is to ensure that the appropriate level of salaries a hypothetical buyer would need to incur to replace the current owner(s) is accounted for. Therefore, it is always important to understand the responsibilities of each owner and their impact on the business.