Alright we got another question, this time it's about buying a business from Bruce: He
asked how should we incorporate the owner salary into the evaluation of the business
we are looking at.
And simple answer to this is, is that what a seller is paying himself; the owner of the
business doesn't actually matter.
An owner's salary is discretionary which means that if there is enough money there, the owner
can select his own salary at whatever figure he wants to earn.
What we want to is we evaluate the cash flow of the business.
So we have the sales and we remove all the expenses, and we remove the non-cash items,
and we remove the items that don't have any impact on us.
Like the amount of interest that the company paid because we are going t have our own capital
structure, our own interest and payments that we are going to consider later in the process.
We want to ask ourselves and then we add back whatever it is that the owner is paying himself.
And we end up with a cash flow called seller discretionary earnings.
It's basically how much money is available to me as the owner if I were to buy this business.
If I bought it 12 months ago, how much money would be under my control right now.
Then what you do is you want to figure out what is the actual fair market value of the
work that the owner does.
So if in this industry the owner is doing the work that a manager in the competing industry
might be paid $60,000 to do.
You then can take that into account.
So if the sellers discretionary earnings are $100,000 and the fair market value of an owner's
work is $60,000, then we know that you could have $60,000 and then there is $40,000 in
excess of that.
At which point we will call that we will call the EBITDA, the earnings before interest tax
depreciation and amortization . So it's how much money is available after a fair market
is paid over for home owner manager.
Now what you are going to find though if you go and look at businesses is that owner salaries
are going to be all over the place.
And sometimes they are dictated by the tax advisors who might say to them, this year
you are going to out this amount as salary and this amount as dividends for example.
Because everything else they got going on in their lives from a tax/planning perspective.
What you are also going to find is that, when you add back the owner's salary.
Maybe they pay themselves 50,000, and then maybe you work out what the fair market wage
of that role is.
You are going to find that people under pay themselves when they are owners.
It's actually quite sad, you end up in a situation where, the SDE (seller discretionary earnings)
actually doesn't add up to the fair market wages of someone doing that role as employee
should earn.
And what that means is that you are not actually looking at a business to buy, you are looking
at a job.
Because if there is no profit in excess of what the fair market value of your labour
is going to be, then there is no way that you can get a return on your down payment
as an investor.
And there is no way that you are going to be able to get the additional money to serve
the debt you have taken on to buy the business.
Which means it's going to come out of your pocket, which means you are exposing yourself
to risk and making an investment all for the privilege for earning less than you would
if you just went out and find a similar job from some other employer.
Anyway, that's how we look at the owner salary when you are evaluating a business.
I hope that was helpful.
If you want to know more about all the different techniques, fundamentals, and mechanics of
evaluating a business for sale, then you really should enrol yourself in my online course,
Business Buyer Advantage which you can find at businessbuyeradvantage.com.
It's the online version of my full day workshop that I have been doing since 2009.
And I know that if this question interests you, you'll certainly enjoy that course.
Thanks and we'' see you next time.