Friday, July 13, 2012

Owner's Discretionary Income (Pt 2)

Part 2 in a Series on Buying a Salon

Owner's Discretionary Income

Owner's Discretionary Income is often the basis for setting a selling price for a salon.

I've found this to be a hugely misunderstood and often misstated number. It's supposed to represent income a new owner would have based on the past performance. The starting point is taxable income from the tax return, then certain adjustments are made. Here is an example of what you may typically see:

Taxable income from tax return                                                     $25,000

Add back:  
Depreciation - a non-cash expense that is unique to the owner.           1,500
Interest expense - a cash expense unique to the seller                          2,000
Personal expenses paid by business                                                    1,000
Owner compensation                                                                        18,000

Owner's Discretionary Earnings                                                       $47,500

Depreciation and interest expense are no-brainers. They get added back every time. Watch out on personal expenses paid by the business. The seller should be able to prove these are valid add-backs. If they can't prove they are personal expenses, they should not be added back - they may actually be business expenses.

Owner compensation - In my experience, when the seller is also a service provider, this add-back is done improperly 100% of the time. Yes, it is customary to add back the seller's (owner's) compensation because theoretically that compensation would be available for you, the buyer. But what if the seller is a service provider? The earnings number includes the revenue generated by the owner/seller. If you are going to keep that revenue (often the seller agrees to stay on as an employee), you are going to have to pay someone for doing the work. This leaves us two choices on how to handle this. 
  1. Add back the owner's compensation, but ALSO subtract out the revenue - the seller and business broker won't want to do this because it lowers their number too much (and therefore the selling price).
  2. Add back the owner's compensation but also subtract out what it would cost to pay someone to generate that revenue (for example what commission would be due on those sales?).
In our example above, let's assume that the seller wants to stay on as a commissioned employee and the commission on her sales would be $22,000 per year. We would need to subtract the $22,000 from the $47,500 leaving us with Owner's Discretionary Earnings of $25,500.

If the seller is basing their price on 2.5 times discretionary earnings or $118,750 (2.5 x 47,500) we have just found justification to reduce the price to $63,750 (2.5 x 25,500).

When the owner compensation add back may be appropriate

In a case where the owner/seller is retiring and the buyer is a technician who anticipates taking on all of the seller's clients personally, the add-back makes sense. Otherwise, beware and don't overpay!

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