Understanding Owner's Discretionary Cash Flow

Nothing matters more to the sale price of a small business than honest, verifiable cash flow, or seller's discretionary earnings (SDE). Many buyers and business brokers go as far as saying cash flow is everything. Over 75% of small business buyers are first time buyers coming out of corporate America. They have one goal: to replace the income stream they lost when they left their jobs.

For these buyers, the cash flow of the business they acquire is their salvation and their main reason for buying. The simplest explanation of SDE is the amount of money a new owner could take out of the business each year. Most components of cash flow are easy to explain, such as net profit and owner's salary. Others are harder to pin down, and a professional business broker can help recast the income statement to determine cash flow.

Net Income

Net income before income taxes is the amount left in a business after all expenses are deducted from revenue. This is the amount federal taxes are based on. Net income can swing more than the normal rise and fall in revenue and expenses. A good accountant keeps net income low for tax purposes, so a small net income does not mean an unprofitable business.

Owner Salary

Owner salary is a large component of SDE. Like net income, it fluctuates for tax purposes. When an owner takes a salary, he pays taxes as both employer and employee, so many owners take a smaller salary and pay themselves through owner perks or net income.

Depreciation and Amortization

Depreciation and amortization are components of cash flow because both are non-cash expenses used to reduce taxes. Depreciation decreases taxable income but does not reduce cash. Lenders include depreciation and amortization in their cash flow calculations.

Interest Expense

Interest is a component of cash flow because it relates to how an owner funded the business, not to the business itself. A new owner might have more capital and no need for financing, which reduces interest expense to zero. Interest can come from bank loans, personal loans, equipment leases, and other debt instruments that may go away after the sale.

Non-Recurring Expenses

One-time or non-recurring expenses can be components of cash flow. In the last completed corporate tax year, if an expense can be shown to be non-recurring or extraordinary, the amount can be added to cash flow. Extraordinary litigation expense is a good example, unless litigation happens every year. Uncollectible accounts receivable above the norm can be included.

A company we worked with averaged $10,000 a year in uncollectible receivables over a five-year period. A large customer went bankrupt owing $130,000, which was written off as bad debt in the last corporate year. The amount over $10,000 would not recur in regular operations, so $120,000 was added to cash flow.

Owner Perks

One of the best benefits of owning a small business is having the business pay for certain personal expenses. Owner perks are expenses personal to a specific owner, so none of these costs transfer to the new owner. If you have a paper trail of the owner perks, a buyer may consider them in his analysis of sale price.

We sold a business that had 70% of its cash flow in owner perks. We would not have listed it had the owner not shown us a complete ledger, check register, and log of every perk. The business sold at full price to the second buyer we showed it to. The most common owner perks a buyer will accept are:

• Car payment
• Spouse and children's car payment
• Car insurance
• Spouse and children's car insurance
• Health insurance
• Spouse and children's health insurance
• Life insurance
• Spouse's life insurance
• 401(k) contributions
• Charitable contributions
• IRA
• Meals and entertainment
• Country club dues
• Travel
• Non-working family member pay

Below is an example of a cash flow calculation:

• Net income: $100,000
• Depreciation: $50,000
• Interest: $20,000
• Owner salary: $80,000
• Owner travel (personal): $5,000
• Owner auto (personal): $6,000
• Owner health insurance: $7,000

Owner's Discretionary Cash Flow: $268,000

A word of caution about including owner perks in cash flow to justify a sale price. When the business will be financed through the SBA or a conventional bank, institutions vary on what they accept as legitimate cash flow. Owners who push a large share of personal expenses through the business can see a lower sale price. It is safer to claim the income and pay the taxes to get the price you want for your business.

Thinking about selling? Start with the number. See what your business is worth.