One of the most common issues that I get asked is why should we deduct the owners salary from future maintainable earnings in business valuations.
The most common reason why the owners salary should not be deducted is that business brokers never deduct owners salaries and always represent the total earnings that a purchaser could earn from the business.
The first thing to remember is that the business brokers are trying to sell the business and they will try to present the business in the best possible way and get the best possible price for the seller.
But because business brokers show total earnings (profit + owners salary) does not mean that is the proper methodology in valuing a business.
When you are looking a buying a business, it is an investment that is separate from the process of working in the business. The investment (purchase) in the business needs to assume that you are going to employ a manger to run the business.
Lets to look at the numbers to see what an expensive mistake it can be.
The business delivers a profit of $50,000 per year after the owner of the business takes a commercial salary of $100,000. The business broker puts forward a sale document that shows the total earnings of the business is $150,000 ( profit + owners salary) and therefore the business is worth $450,000. Assuming a capitalisation factor of 3, we believe the business is worth $150,000.
A capitalisation factor of 3 assumes a return on your money of 33%. An investment in a small business is risky and therefore demands a higher return. Safer investments like term deposits in Big 4 banks only offer 5%, but you are very likely to get paid 5% per annum and get your capital back at the end. An investment in a business is riskier and you might not get a return on your money or even lose your initial investment. Greater risk equals greater return.
If you bought the business for $450,000, your return on your investment is only 11% without any return of capital.
If you borrowed $450,000 repayable over 10 years at 10%, the repayments would be $73,250 per annum, considerably in excess of the earnings of the business at $50,000. If you quit your job earning $100,000 per annum to buy this business you would be $23,250 worse off, plus an even bigger debt to service.
In the alternative, lets say you had $450,000 in the bank paying $22,500 per year in interest. Would you withdraw that money and invest it into a business that may pay you $50,000 per annum but may actually not pay you anything and actually result in you lossing all your investment. For that level of risk, you would want even greater return on your money like 33% or $150,00 per year.
If you bought the business for $150,000, the return would be $50,000 per annum. If you decided to purchase it via debt, the repayments would be $24,400 per year (10 years at 10%).
It should be remembered that most small businesses do not have any goodwill value, they fail to even generate a commercial salary for the owner of the business.