Addbacks – How To Calculate Your Management Company’s Earnings.
It’s Actually Pretty Easy To Figure Out Your Cash Flow – Here’s How
It’s a pet peeve of mine. Business brokers and M&A advisors absolutely love making the business valuation process seem complicated and difficult. I guess we’re always looking for ways to justify our fees.
Well guess what? It isn’t really all that difficult to determine your earnings. If you’ve got accurate financial statements (a BIG if) you should be able to knock this out in 90 minutes or so.
There are three common ways to measure a company’s cash flow when selling a property management business. All three have distinct advantages and purposes.
- Seller’s Discretionary Earnings – SDE is the most common number in small business sales. It will almost always be employed when valuing companies with less than $5 Million in revenues. That’s because smaller company’s are usually owned by an individual or couple as owner/operators rather than a corporation with multiple shareholders. It answers the question “what is the total return of cash and benefits flowing to the owner?”
- Earnings Before Interest, Taxes, Depreciation & Amortization – EBITDA is used for valuating a company based on the return on investment. It answers the question “what is the return to the owner for a cash purchase of the business, after a market rate of compensation for work that the owner performs in the business (or for hiring someone else to perform those functions) has been subtracted?”
- Discounted Cash Flow – DCF analysis uses the “time value of money” concept to determine company value based on future income streams. It is typically used to measure the attractiveness of much larger companies, say with revenues of $100 Million or more.
All three methods pull numbers from your Profit & Loss Statements. We valuation specialists also look critically through your Balance Sheets and Cash Flow Statements to reach value conclusions but those are not directly utilized in our earnings calculations.
Unless your management company is doing $25 Million or maybe $50 Million in revenues, you’ll want to focus exclusively on figuring out your SDE. It will be the broadest and most favorable calculation available. Your earnings for SDE will be larger than your earnings for EBITDA so it makes your company look better to investment buyers.
Don’t be confused by various terms people throw around for Seller’s Discretionary Earnings. It can be called recast earnings, normalized earnings, seller’s discretionary cash flow, adjusted cash flow or adjusted net income. SDE is the official terminology advocated by the International Business Broker’s Association (IBBA).
The IBBA has defined how SDE is to be calculated. A business’s overall SDE is calculated as an average of the SDE for the 2 or 3 most recent full years, plus the current year in progress. If there is a strong trend in the earnings (up or down), much more weight will be placed on more recent years.
SDE is calculated for each year based on information from the business tax returns, the profit and loss statements and owner estimates. All of the following categories are added together in the SDE calculation. Here is what it includes:
- Pretax net income. This is the bottom line number on your P&L. PLUS…
- Owner’s total compensation. This includes one or two salaries paid to the owner plus profit sharing income paid to all the owners. If there is a second salary being paid to a spouse or family member, you must subtract whatever salary amount would be needed to replace his/her workload. WARNING: These salaries must be stated incomes appearing on your P&L and tax return. They can not be funds sucked out of the business through draws and distributions. PLUS…
- Employer portion of payroll taxes paid based on the W2 salary of one owner. PLUS…
- Business interest expense (because business debt is a “non operating expense” and assumed to be paid off). Do not plug in expenses for mortgage interest. PLUS…
- Depreciation and amortization (non cash expenses). PLUS…
- Discretionary expenses or personal perks paid by the business but which really benefit the owner. Common examples include the owner’s health insurance, personal use of automobiles, personal travel, personal meals and entertainment, etc. PLUS…
- Adjustments for extraordinary, non recurring expenses or revenue (e.g., expenses incurred in a one-time lawsuit or damage from flood or fire would be added back. Revenue and expenses from a major discontinued product would be removed. PLUS…
- This can get tricky. If you are enjoying rental income that your buyer will not, you must make a negative adjustment and subtract it from earnings. If a new owner’s rent will be different from yours, you must make an adjustment, either positive or negative. For example, if your business currently has two leased locations but only one is necessary to run the company, you can addback the rent you’re paying on the second office. On the flip side, if you’ve been operating from a home office and the business cannot reasonably be run without a physical space, you’ll need a negative adjustment for a fair market rent expense.
What Precisely is a Discretionary Expense?
Discretionary expenses are defined to be ones that the business paid for but are primarily of a personal benefit to the owner. Typical expense categories (places to check on your tax returns/ P&Ls) are owner medical or life insurance, travel, automobiles, meals and entertainment, dues and memberships.
To qualify as discretionary, each expense must meet all 4 of these criteria:
1) Benefit the owner(s)
2) Not benefit the business or the employees
3) Are paid for by the business and expensed on tax returns and P&Ls
4) Be documented and verifiable by a prospective buyer as discretionary.
Illustrative examples of expenses that would NOT qualify would include:
- Medical benefits for an employee
- Counting all meal & entertainment expenses as discretionary even though dining with clients is a critical way of building relationships
- Counting all travel as discretionary, even though some travel is necessary for business (such as to a trade show)
- Counting all auto expenses as discretionary even though the vehicles are used to deliver products or by employees
- Any marketing or promotion related expense even if it “didn’t work and it wouldn’t be done again”
- Expenses for a Rotary or club membership if any clients are gained through such memberships
- Counting unreported cash sales unless the buyer has a straightforward means to verify such sales
- Counting dozens of personal purchases on a credit card where the card is also used for business purchases, or where the expenses are buried in a much larger expense category or several expense categories and therefore nearly impossible for a buyer to verify.
It is better to be conservative in your estimates than aggressive. If buyers believe you are exaggerating the discretionary expenses, they will conclude you are untrustworthy and likely making other misrepresentations. Worse, if they purchase the business based on your misrepresentations, you may be guilty of fraud.
So What Are Non-Operating & Extraordinary Expenses?
Extraordinary expenses are defined to be ones that 1) the business paid for 2) are truly unusual or exceptional in nature and 3) documented and verifiable as extraordinary. By their nature there are no “typical” extraordinary expenses. Examples might include expenses associated with natural disasters, a move of location, or a lawsuit out of the ordinary course of business.
Examples of expenses that would not qualify would include a marketing campaign that failed, headhunter fees to replace a manager that quit, research and development of a product or service that was later scrubbed. Keep in mind, most businesses list nothing in this category so you need to be conservative and cautious in your calculation.
Non operating revenue is unrelated to the business operations, such as interest revenue, rent from a property owned through the business or sale of equipment or part of the business. Non operating expenses might include those to repair or fix up a building owned by the business.
The Question To Ask Yourself
In trying to figure out addbacks and adjustments to reach an accurate earnings number, ask yourself this question – if another guy owned my business right this minute, and operated it in the exact same way, in the same place, with the same employees and clients, what income and expenses would be different for him? Those are the adjustments you need to make to your net income figure on the profit and loss statement.
Very often, addbacks are not 100% of an expense category. For instance, your company’s annual automobile expenses may be $10,000. The business does own a couple cars but you also run your personal car’s gas, repairs and licensing through the company. So you’d call that a 25% addback, or $2,500. Maybe you expense $15,000 for bookkeeping and accounting but included in that is your own personal returns and tax help. That could be a 50% addback. Do your best in making an accurate estimate of what is a personal benefit to you versus a business benefit to the company.
Once you finally have an earnings number for each year, the fun starts. You now have choices to make. Do you claim your management company has an SDE based on last year’s numbers? Or do you use an SDE that’s averaged over three years? Or do you use a 3-year weighted average, where last year’s earnings are given greater weight than those from two and three years ago?
Depends on who’s asking. Most will rely on a Trailing 12, an SDE calculation based on the last 12 months in which monthly reconciliations were completed. They will compare the Trailing 12 performance to previous years and draw opinions about how to treat it.
One reason the property management industry is very popular with business buyers is that revenues are typically rather consistent, without roller coaster rides seen in many other industries. Even if their clients’ properties are struggling with vacancy, maintenance or delinquency issues, the management company’s revenue will remain pretty consistent. New clients come, old clients go but the income stream is often stable.
If there isn’t a great deal of difference between your Trailing 12 and last year’s P&L, lenders and valuators will use last year to calculate the SDE number. Lenders always go back to the tax returns to underwrite a deal.
Once you have your earnings number, now you need to figure out how to use it in calculating the value of your company and the price a buyer may be willing to pay. That’s the next part of the valuation game. Check our site to pick up the process from here.
This post intended for informational purposes only. It is not intended to constitute legal, tax or investment advice. There is no guarantee that any claims made are accurate or will come to pass. ManageVisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.