by Scott Bushkie. CBI, M&AMI
At Cornerstone, we have a rule that before we take on any client we perform what we call an estimate of value (EOV). Simply put, an EOV is our professional opinion of what the business might sell for in today’s market after analyzing business, industry and market trends.
One of the keys to coming up with the right value is to correctly recast the financials. That means we’re trying to accurately depict what the bottom line really looks like after adjusting for personal and unusual (one-time) expenses.
One of the key areas we look at is owner compensation. If you’re buying a business, you’ll want to take a close look at what both the owner and the employees are making.
Let’s say we have two relatively similar companies, both in the same industry, and both with a bottom line of $1 million. One business owner has an annual compensation of $80,000 while the other gets $500,000 between salary and bonuses. Clearly, these companies should be valued differently.
The trick is to do enough research to figure out what the owner’s role in the company truly is. It could be the owner spends most of the year in Florida and has a general manager in place to run the business. In that case, most of the owner’s salary would be added back to the bottom line.
Or, it could also be the case that the owner is working 100 hours a week serving as president, VP of sales, and CFO. In a situation like that, as a buyer, you have to ask yourself, “Can I do all this work myself? How many people do I need to hire to maintain operations and have an acceptable quality of life?”
What we try to do with our EOV is to figure out what the owner’s role is and what it would cost to replace him or her with an equivalent employee at a fair market wage rate. We use that number in place of the owner’s compensation and then adjust the bottom line up or down accordingly.
Comparing Compensation. Using the example above, let’s assume the owners have similar duties and the fair market replacement wage is $150,000. That means we subtract $70,000 from the bottom line of one business and add back $350,000 to the other.
Now, using our normalized numbers, Company A has earnings of $930,000 and Company B has earnings of $1,350,000. That’s a 37% difference. Next, let’s compute business value based on a 4.5 multiple and you can see the significant difference in business value: $4,185,000 versus $6,075,000.
Wages and Bonuses. The other compensation issue you want to look at is whether key employees are being paid a fair market wage. If so, great. If not, you might have to factor that into your analysis. Are employees going to need a raise soon, and what is that going to do to your cash flows?
Also, be wary of adjusted financials that add back discretionary bonuses. Do employees receive a “discretionary” bonus (emphasis on the quote unquote)? If employees have been given bonuses the last three years running, they may be technically discretionary, but I sure wouldn’t want to be the new guy who didn’t pay out in year four.
Valuation Basis. And with all this talk of normalizing financials, one item that can confuse people is whether they’re looking at an SDE method (seller’s discretionary earnings) which adds back the owner’s salary, or an EBITDA method (earnings before interest, taxes, depreciation, and amortization) which doesn’t.
Neither method is right or wrong, you just want to make sure you don’t use an EBITDA multiple with SDE, or vice versa. You could end up either overpaying or underbidding and missing out on a great opportunities.
Main Street valuations, or businesses valued under $2 million, typically rely on SDE to calculate value, while lower middle market deals relay on EBITDA. Most of the time, the big difference between the two is owner’s salary and bonuses.
Local Advisors. If you’re buying a large company and need help evaluating roles and wages for a key management team, I recommend contacting an HR consultant like Diane Biersteker. As the former head of HR, she led one area company through more than 13 M&A transitions before opening her own firm.
I’m also a fan of Carol Dean at HIRE. She’s another HR consultant I’ve looked to for help when growing the Cornerstone team. As a buyer, these are the kind of people you need supporting you as you do your due diligence on roles and compensation plans in any major acquisition or are looking to add key people after a purchase.
