Compensation Dollars vs Investment Dollars

I didn’t know whether to laugh or be insulted. While I love it when a potential client does their homework, there is nothing more frustrating than when they have an advisor who is in over their head.

I recently had dinner with a business owner interested in retaining me to sell his business. His business was smaller than I normally handle, but I met with him in response to a request from a mutual friend.

When I got to the restaurant I met the business owner and his son (we’ll call him Ed). The owner told me he was ready to retire and start traveling. I asked him how much he wanted for the business, at which point Ed chimed in, “We’ve done our homework, we think the business is worth $1.25 million.” I had no frame of reference as to the size or profitability of the business, so I asked Ed how he got to that number. He explained that his dad’s company generated an EBITDA of $250,000 and, based on his research, he determined that companies like his dad’s should sell for a multiple of 5, hence a $1.25 million valuation.

I know Ed had his dad’s best interest at heart. I certainly didn’t fault him for pushing the envelope to get the most he could for the business. However, as I learned more about the business, I realized there were two critical errors in Ed’s financial logic that led me to conclude he wasn’t as well prepared as he represented. Mistake number one: the EBITDA did not include a deduction for rent since his dad owned the building from which the business operated. Mistake number two: the EBITDA did not include a deduction for compensation for his dad.

To be clear, Ed was correct in believing the business generated $250,000 per year for his dad. But $250,000 is not the annual investment value of the business because it does not include the full cost to operate the business. Let me break it down this way. Once the business is sold, we assume the seller will expect the buyer to pay rent, estimated at $50,000 per year, so adjusted EBITDA is now down to $200,000. The buyer will also want to be compensated for the work to run the business or pay someone to run the business; let’s say the market comp to run a business like this would be $125,000. This brings us to an adjusted EBITDA of $75,000, which is the investment value of the business. Most businesses like this, at this size, would sell for a multiple of 3 to 4 times EBITDA, so the business is only worth $225,000 to $300,000.

Let me assure you, it is a hard conversation to tell an owner their business is worth 25% of what they thought coming into the meeting. That’s why I go to a lot of effort explaining my logic. Once an owner (and their advisor) understands the difference between compensation dollars and investment dollars, they usually accept the conclusion. In my many years of having these conversations, I’ve noticed this confusion is especially acute for small professional businesses (doctors, lawyers, accountants, chiropractors, dentists, etc.). Compensation dollars to run the business cannot be add backs when calculating the investment value of a business. I know Ed meant well, but had he learned this valuation lesson a few years earlier, he might have been able to help his dad reach a better exit outcome.

JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. https://www.amazon.com/Home-Pros-Guide-Selling-Business/dp/1599329239 .  He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The story above is true, but the names and fact patterns above have been changed to preserve the parties’ identities.

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Tennessee Valley Group

Jim Cumbee established Tennessee Valley Group to help business owners fulfill their dreams for life after business ownership. It’s a mission that his 30+ year career history had prepared him well for—in addition to being an attorney, transition mediator and business broker, Jim has been a buyer, seller, and entrepreneur. His broad range of experience gives him unique insight into how business buyers and sellers can achieve their goals.

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