28 Jan Owner’s Responsibilities Have a Major Impact on Value
To understand how an owner’s involvement in a business affects its value, one must first understand how the company being valued is operated. The owner’s involvement in any business can generally be described as one of the following:
- the current owner(s) is absentee (or has minimal responsibilities)
- the current owner operates the business on a full-time basis
- multiple owners operate the business
Let’s take a closer look at each of these scenarios to determine how an appraiser should adjust the business’s discretionary cash flow, specifically Seller’s Discretionary Earnings (SDE).
First, here are two important definitions:
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).
Scenario 1: owner is absentee (or has minimal responsibilities)
If the subject company is absentee-owned (owner has no daily involvement in the company’s operations), the company’s cash flow should be adjusted to reflect this fact. Assuming that the current owner is paying a manager to operate the business, this manager’s salary (plus related payroll taxes and benefits) is added back to the company’s cash flow (EBITDA), 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, 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 officer’s compensation reported on the company’s actual financial statements should be added back to the company’s cash flow. This could be in the form of W2 wages or Guaranteed Payments to Partners (for Partnerships) – this typically doesn’t include distributions, which are not reflected on an Income Statement.
Scenario 3: there are multiple owners
In the case that a business has two owners that are both operating the business full-time, it could be deemed that a hypothetical buyer would be able to replace one of the current owners and would be required to hire a replacement for the other. For instance, one of the owners could be responsible for running the daily operations while the other owner is responsible for the payroll and finances. In this situation, the appraiser should find a fair market replacement salary for each of the current owners’ responsibilities. Both officers’ compensation would be added back into the company’s cash flow and one fair market replacement salary would be deducted from the company’s cash flow.
Keep in mind, if the second owner is not working and is simply an investor, no adjustment for the second owner is required. If the second owner is working part-time, and the appraiser deems it to be reasonable, the appraiser could add back both officers’ compensation, and the fair market replacement salary for the second owner could be adjusted to reflect part-time hours. In a situation where there are more than two owners, the appraiser must use discretion to analyze the hours worked for each owner, and decide how many replacement salaries are required.
Owner’s involvement plays a critical role in how a business is valued. Regardless of how involved an owner is in the company’s operations, normalizing salaries and wages to reflect a single hypothetical buyer’s cash flows for the future allows an appraiser to arrive at an accurate fair market value of the company.