When Valuing Small Businesses
When valuing small businesses, including owner-operated optometry and medical practices, arguably the most important item is Seller Discretionary Earnings (SDE). It is defined as the Net Income as reported on a tax return + Interest Expense +Depreciation Expense + Amortization Expense + Owner’s Compensation + Owner Perks. Basically it is what the owner is left with after paying all his business expenses.
SDE instantly cuts through all the bullshit and tells somebody how much money is actually going into an owner’s pocket. Depreciation, interest, and amortization are added back to what is listed as profit on the tax return because those items are non-cash items – they are accounting items that are reported on an income statement (aka P&L) but don’t represent actual cash outflow during that period.
Owner perks need to be added back because they aren’t really necessary to operate the business. They are used commonly by business owners to lower the net profit their tax return shows, which lowers their tax burden. Auto expenses and meals and entertainment, for example, may be legal to deduct according to the IRS, but in most cases really not necessary to run an optometry office. (Perhaps we’ll save the shadier discretionary expenses I’ve seen for another article.)
The Owner’s Compensation Needs
Owner’s compensation needs to be added back because what an owner takes out as salary according to the tax return is irrelevant. Let’s look at tax returns for Doctor A and Doctor B. Each office has sales of $600,000, Cost of Goods expense of $200,000, and General Office Overhead expenses (for simplicity we can include staff salaries here) of $200,000. Doctor A reports a Salary of $200,000 which results in a net profit of $0.00. Doctor B reports a Salary of $1.00, which results in a net profit of $199,999. Aren’t these two offices identical in profitability? The SDE for both offices is $200,000; both doctors are taking home that amount each year.
|Doctor A||Doctor B|
|– General Office Overhead||-$200,000||-$200,000|
|– Doctor Salary||-$200,000||-$1|
Why is SDE important to a buyer? Because it is the amount he will use to pay himself as well as make payments on a bank loan. Using our example above, if a buyer pays himself a salary of $150,000, that leaves $50,000 per year for loan payments. How far will that go? In this case, it would support a loan for $400,000 at 4.5% interest with an amortization of ten years.
What if the SDE was only $175,000? If the owner again takes a salary of $150,000, now there is $25,000 left for financing. Assuming the same interest rate (4.5%) and amortization (10 year), the new buyer would only be able to take out a loan for $200,000.
That’s a big difference. See how important SDE is in selling a practice?