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When Selling a Business, How Is The Owner’s Time Accounted For?
By Quiet Light
I was recently tagged in a tweet from Centurica and Bryan O’Neil regarding a post that Bryan wrote titled “Are All Website Brokers Misrepresenting Financials?” The argument of his post is that it is very difficult to determine the expected ROI when selling a business without knowing just how much time an owner is spending on the business.
As Bryan wrote:
As a buyer looking for a passive investment, all that I’m interested in is what the price multiple is going to be once I have outsourced all of the operational aspects of the business.
Similarly, as a buyer looking for a lifestyle business, I’m interested in what the price multiple is if I stop using any freelancers and put in 4-8 hours a day of my time.
But as it stands, none of this information is available until the buyer takes out the Prospectus, reads it through entirely to determine the level of owner operation, and then applies their calculations.
He continues further with the observation that some buyers feel as if brokers are directly misrepresenting financials by not taking into account the owner’s time on the income statements:
To make matters even worse, a number of buyers constantly accuse brokers in misrepresenting financials (or allowing sellers to do so), through marketing businesses that require significant owner operation but not taking this into account on the Income Statement.
This begs the question: how should an owner’s time (and compensation) be handled on a profit and loss statement?
A Solution For This Question Exists (It Has Been Around For a While)
How to account for an owner’s time on a business is not a new problem, and it is not a problem that is unique to the online world. Brokers in the traditional M&A space have a standard approach to how they handle an owner’s time on the business, and this is the same approach we use at QLB. The solution is to calculate and represent the Seller’s Discretionary Cashflow.
We have written on this topic before in the resource article “Seller’s Discretionary Cash Income: What Exactly is It?” and Jason also wrote on this topic on our blog in his post “The True Value of SDE as a Valuation Metric“.
Within this calculation, there is no argument about how an owner’s time is treated. The primary owner’s salary is always added back into the overall owner benefit and an expense is never taken for the primary owner. In the event that there are two owners, only one owner will have his time and earnings added into the overall profits while the other owner(s) have their time and earnings show up as an expense.
Why SDI? Because It Reduces Presumptions
Using seller’s discretionary income has been widely accepted in pretty much every broker’s niche and is also adopted by the IBBA as a fair way to present a seller’s financials.
Why has it been so widely adopted? Because it doesn’t require that the broker make presumptions on your behalf. It also allows you to make your own financial assumptions from a normalized starting point.
Do you really want to start with a P&L in which you need to unravel a number of broker-based assumptions of what something should cost? What if my assumptions are bad or poorly based?
It’s not that SDI eliminates all presumptions – there are some cases in which assumptions need to occur, but, it minimizes their occurrences as much as possible. Furthermore, any trustworthy broker will not only disclose their SDI calculations, but they will also be clear in any presumptive expenses they had to make.
Why Reduce Presumptions?
I had the opportunity to sit down with one of our buyers at a local coffee shop to talk business. During our conversation, I learned that he had a full-time programmer that he paid $4/hour. He has been using this developer for several years, knew him, trusted him, and got great work out of him.
Conversely, I was talking to another buyer about one of our websites for sale, and he told me that the redesign of the website with his team would cost him over $25,000!
Every entrepreneur develops their own philosophy about how to run a business. One entrepreneur may be fine with hiring low-cost help and being very hands-on with their instructions. Another entrepreneur may believe that hiring an all-star team is the best route to success, even if it costs more.
It is not the broker’s position to provide those assumptions for you. A good broker will give you the starting point so that you can easily apply your own assumptions.
How Do We Actually Value An Owner’s Time?
Most of the time when an owner lists their salary as an expense on their P&L, they are not listing it because it is their ‘compensation’ for their time. Typically they pay themselves a salary to comply with IRS expectations. Most online business owners get compensated through distributions from their company.
Consider an example publication that has gross revenues of $120,000/year and has expenses of $40,000/year. The IRS expects that the owner will compensate them at a reasonable salary. But the problem is that paying a salary is often less tax advantageous than simply taking an owner’s draw or distribution from the company. Because of this, the owner may decide to pay themselves $40,000.
Overall the owner is actually benefiting with $80,000/year ($40,000 in salary and $40,000 in distributions), but on the P&L their time is represented by $40,000. Should we use that as a ‘cost’ for the owners time? Or should we simply pick a number out of the air for a ‘reasonable’ replacement cost? What skill level replacement do you need? Who says what is reasonable?
The point is this: the owner’s salary expense on a P&L is usually not as indicative of the value of their time as it is indicative of their individual tax situation and level planning.
The Real Solution: Education
The problem Bryan noted in his blog post isn’t that a good method or standard hasn’t been established to value an owner’s time, the problem is that most brokerage firms in the online space do not understand (or even know) of the standard. And because the brokers don’t know this standard and do not use it, buyers no longer know what to expect.
Fortunately for our industry we have people like Bryan writing on these topics and spurring discussions like this. As someone who works with a lot of buyers, his voice carries weight with it. Hopefully the rest of the industry will also jump on board and think hard about how they want to approach both financial disclosures and common calculations.