There is usually a very healthy debate between buyers and sellers regarding each side’s calculation of the total Owner Benefits (OB) figure. First,
let’s clarify what exactly is Owner Benefits, which can be referred to as Owner’s Cash Flow, Seller’s Discretionary Earnings, Adjusted Earnings, and several other names.
Nevertheless, the objective is to provide a figure of the actual funds that a new owner can expect to have themselves as salary, to service debt and grow the business based upon the assumption that the financial picture of the business will remain the same post-sale and using the prior financials to paint this picture.
Conceptually, it is the correct way to present the financials. The problem of course is making sure the components of this figure are correct.
The formula used is to arrive at the OB is:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation LESS Allowance for Capital Expenditures
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life.
For example: if the company purchases a $125,000 piece of equipment and its useful life is determined to be 10 years, then each year the company can deduct $12,500 off its Net Income to reduce its tax burden. However, it is not an actual cash transaction. No money is physically leaving the business or changing hands. Therefore, this amount is added back.
But, and it’s a big one,
rarely can you just add back all of the Depreciation
. What about the costs to eventually replace the equipment that a new owner will incur? For that reason, an allowance (deduction of the Owner’s Benefit and specifically the Depreciation portion) for future capital expenditures may be needed.
A word of caution: this allowance and offsetting reduction of the Owner Benefits is almost never shown in the figures a seller presents but absolutely must be included. It’s a simple and correct argument that buyers must make when applicable and one that sellers and brokers cannot rebut.