Business owners should always know the value and marketability of their business. But many do not.
Business owners should also know the factors that drive valuation and improve the attractiveness of their organizations well ahead of a sale. Every business is unique and, therefore, each has its own unique value proposition. This sounds like common sense, but it is often taken for granted.
From an M&A perspective, a proper business valuation analytically determines the current fair-market value of a company as an ongoing concern. In other words, how much would a new owner pay and risk to take over the operation and move forward in its present state? It is important to remember that “Shark Tank” and high-flying technology stocks do not apply – there are no speculative buyers on Main Street.
With that said, what is the key driver of valuation? The answer is seller discretionary cash flow, or SDCF: generally, the total amount of profit and discretionary-expensed items that a company has on a yearly basis.
SDCF is the true benefit of ownership and it should be monitored continuously. When it comes to proper valuation, discretionary cash flow is king because it clearly shows true profitability and a firm’s real ability to continue operations.
In determining seller discretionary cash flow, some items are found right on the tax return and some personal items are more “buried.” These items include all things that a new owner would not have to expense in order to maintain the proper operations and viability of the business.
Let’s add up the items that can constitute seller discretionary cash flow for a fictitious business with $2 million in gross sales in a particular year:
1. Taxable income – net profit shown on first page of return: $80,000
2. Compensation of officers – usually W2 amounts paid to ownership or guaranteed payments to owners: $190,000
3. Interest expense – debt related: $10,000
4. Depreciation and amortization expense – equipment related: $45,000
5. Charitable contributions – donations and gifts: $2,500
6. Overpaid family – spouse is bookkeeper: $30,000
7. Auto expenses – payments, gas, insurance, etc.: $12,000
8. Insurance expenses – medical, life, disability, etc.: $36,000
9. Pension expense – amount of company match on owner’s W2: $4,500
10. Legal and professional expense – personal returns and lawsuit defense: $5,000
11. Travel and entertainment – personal portion: $18,000
12. Other benefits – cell phones, misc. supplies, etc.: $6,000
13. Excess rent – overpayment of rent on personally owned property: $36,000
14. One-time or unusual expense – bad debt, audit, new roof, etc.: $10,000
In this case (and in most instances) the tax return does not tell the whole story. Even though this business only has $80,000 of net taxable income, the total seller discretionary cash flow is $485,000 – that amount is the true benefit of owning that business in that given year. That is the number to track on a yearly basis and that is the number that drives the market value of a business.
Gary W. Herviou is vice president of A Neumann & Associates LLC, a mergers and acquisitions advisory and business brokerage firm with offices along the East Coast.