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What is the Problem with Discretionary Earnings and Why It Matters?

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If you have ever tried buying a very small business you have probably came across the terms “Seller’s Discretionary Income”, “Owner’s Discretionary Cash Flow”, “Discretionary Income”, etc. So what is “Discretionary Income”?

In short, “Discretionary Income” is pre-tax income plus the add-backs and adjustments. The add-backs include (1) the non-business expenses, i.e. the spending that benefits the owner, (2) one-time expenses that happened in the last year but are unlikely to repeat in the foreseeable future, and (3) the salary of one of the owners.

Sounds simple enough. So, why is discretionary income invariably at least a little contentious when sellers and buyers are working on a transaction? And, more importantly, why do the disagreements about discretionary income kill so many deals?

savings-2789153_1280 What is the Problem with Discretionary Earnings and Why It Matters?

In order to compare apples with apples, it makes sense to use a metric which includes the owner’s salary. For example, it would be too easy to show unrealistically-high earnings simply by paying a very low salary to the owner. On the other hand, a solid business where the owner is drawing an above market salary would look like a bad purchase if the owner’s salary is treated like an expense, instead of a benefit stream to the owner.

In addition, quoting discretionary income instead of EBITDA is a standard approach when selling a very small business. Since most sellers quote their discretionary earnings, a seller that would feature EBITDA or pre-tax earnings may appear comparatively less attractive at first sight, particularly since some buyers do not necessarily know the difference when they first start looking for a business to purchase.

In other words, the case for using discretionary earnings – when comparing very small firms – is very strong, regardless of what an investment banker that only worked on $25+ million deals tells you. Needless to say, there are downsides to it as well. Before looking into them, let’s consider the other factors for determining the discretionary income amount.

Obviously, almost every buyer will want to ascertain that the revenues and the expenses in the profit and loss statement are accurate and that the net income figure is reliable. In fact, often the focus of the buyer’s due diligence will be just that.

Secondly, in smaller transactions, a large percentage of the overall benefit to the owner will be in the form of non-business-related spending. The sellers will understandably want to communicate those benefits to the potential new owners.

That is all fine and well. However, it still sounds like there should be few disagreements about discretionary earnings figures.
Yet, time and time again, the sellers and the buyers debate over the issue. The most frequent source of disagreements, and the areas you should pay close attention to when researching a firm you would like to acquire, are the expenses hiding in plain sight, i.e. false add-backs. Those may be recurring expenses that the owner would like to treat as one-time expenses and actual business expenses that the owner would like to present as personal or other non-business spending.

Some examples are:

  • Recurring One-Time Expenses: The buyer may suspect that many one-off expenses are actually recurring expenses that are necessary to run the business. Say the seller updated their website last year. Is the same expense necessary the following year? Well it depends. It can certainly be argued that no major overhaul is needed every year. However, it is more likely that it will be necessary to invest in the company’s online front-end just to keep up with the competition.
  • Not-So-Non-Business Expenses: The seller will certainly argue that his wife’s Range Rover is not really a delivery vehicle, and most buyers will accept that. However, some sellers will claim that the company’s annual dinner in mid-December is a non-business expense or even that the key employee’s health insurance is a non-business expense. Needless to say, the latter might be a tougher sell.

 

Predictably, oft times the sellers’ definition of add-backs will be overly expansive. On the other hand, the buyer may be unwilling to recognize even the most obvious non-business spending, such as a weekend trip to Aspen.

Nevertheless, it is not paramount for the buyer and the seller to agree on the definition of the discretionary income, and conversely what the actual figure is. They can both operate on their own valuations and the negotiations will function equally well as if they used the same metrics, as long as they know the true nature of the spending from their perspective.

In other words, the danger for the buyer is in not fully understanding the cash flows they are buying, because of the assumption that the seller used the same definition. Therefore, the buyer’s goal is to establish whether the definitions match and, if they don’t, to adjust the valuation.

The danger for the seller is that the buyer may consider the seller not trustworthy because of the overly expansive discretionary earnings definition. The value of the business boils down to the expected cash flows divided by the perception of the risk. If the buyer thinks that the seller is not honest – whether the assessment is true or not – the buyer’s perception of the risk will go down. As a consequence, under the best of circumstances, the amount the buyer is willing to pay for the business will go down.

In short, the definition of discretionary income matters if one wants to compare apples to apples. The issue, unfortunately, cannot ever be resolved because of the competing interests and the zero-sum nature of the interaction. However, it is in both parties’ interest to be transparent, because it is very unlikely that either side will not have a very close look into the quality of earnings.

Fortunately, once both sides have a good understanding of the income and expenses, they can successfully negotiate a deal without actually agreeing on the definition of discretionary earnings.
Yes, the universe is good.

 

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