If you borrowed money from a bank and have covenants, you are aware that the financial institutions look at your cashflow of the business often called EBITDA, earnings before interest, tax, depreciation and amortization. This determines the amount of cashflow that you have to finance your existing loans and leases. When you are selling the company, many buyers look at normalized EBITDA meaning the cashflow that a new owner would have if the old owner left and stopped putting through discretionary expenses which are not related to the ongoing operations of the business. What does this mean? If you are a private corporation, you may do income splitting and have your spouse on the payroll. She/he may or may not be working. If she is not working then her salary is really part of your compensation therefore her expense should not be continued after the sale of the business.
If the company does entertaining but a lot of the entertaining is with friends and family and not related to the business, that is part of normalized income. Often, people will try to make their travel plans tax deductible by visiting one client and then writing off the vacation. Is this deductible, that is open for negotiations. If you were required to see the customer, then definitely, this is a legitimate expense however if your trip included your whole family, the travel expense may exceed what it should really be. If you have a cell phone or blackberry and your entire family has one too but they are not active in the business, these type of expenses will not be continuing in the business. If you consume part of the goods for personal use and expense them through the business such as personal food in a restaurant, then the cost of goods sold are overstated.
The trick is now trying to prove all the expenses which you are adding back to EBITDA to create normalized income are legitimate add backs. Remember, the compensation for the owner may be taken out as salary but if you can replace his/her position with someone else for a lower salary, then part of their compensation can be attributed to be a return of capital and not a true expense of the company. For example, if the owner takes a salary of $250,000 but you could replace them with a person making $150,000, $100,000 of the owners salary is paid by virtue of his share ownership and this should be added back to normalized income. Likewise, if the owner is taking a salary of $20,000 to improve bottom line but he needs to be replaced with a person earning $150,000, then you need to subtract $120,000 from normalized earnings. If you say that some of the expenses are discretionary, you now have to prove that the expense really was discretionary. Since adding back as many expenses as possible raises the price of the business for sale, the onus on proving the add backs are not related to the business falls to the seller of the business and not to the buyer of the business.
Once you have determined the free cashflow of the business, you can now determine the value of the business.
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