How buyers read a P&L, and why it is not how you prepare one

Adjusted earnings is the number that gets multiplied

Nobody buys reported net income. Buyers price off adjusted earnings — reported income restated to show what the business produces for an owner-operator or, at larger sizes, for a financial owner. Two conventions apply depending on size and buyer type.

• Seller's discretionary earnings (SDE). Used for owner-operated businesses, typically under roughly $1 million of earnings. It adds one owner's total compensation and benefits back to the earnings, because the buyer will be that owner.
• EBITDA. Used where the business runs with management in place and the buyer will not work in it. Owner compensation is replaced with a market-rate manager's salary rather than added back entirely.

Applying an EBITDA multiple to an SDE number, or the reverse, is the most common valuation error owners bring to a first meeting. It is also why rules of thumb heard at industry conferences are usually wrong by a wide margin.

The multiplier effect

If a business trades at a three to four times multiple of adjusted earnings, then every dollar that never reached the earnings line costs three to four dollars of sale price. A run-rate of $60,000 a year in personal expense that cannot be documented is not a $60,000 problem — it is a $180,000 to $240,000 reduction in what the owner receives at closing, repeated for every year the buyer averages.

This is the conversation to have with an owner three to five years out, not three months out. Nobody is asking anyone to overpay tax. The point is that the tradeoff should be made deliberately, and that undocumented spending is the worst version of it: the owner gets neither the deduction's full benefit nor credit for the earnings.

Add-backs that hold up

• Owner compensation and payroll taxes above a market-rate replacement salary
• Personal vehicles, personal insurance and personal travel run through the business, with support
• One-time legal, settlement or professional costs that will not recur
• Non-cash items: depreciation, amortization
• Interest on debt the buyer will not assume
• Rent above market where the owner also owns the building, restated to market rent
• Documented start-up or expansion costs of a discrete initiative
• Family members on payroll who do not work in the business

Add-backs that get rejected

• Adjustments with no invoice, statement or ledger detail behind them
• Recurring costs described as one-time because they varied year to year
• Cash sales that were never reported — unreported income is not add-back eligible, full stop
• Deferred maintenance and capital expenditure the business will genuinely need
• Hypothetical improvements: what the business would earn if it were managed differently
• Owner labor that the buyer will have to hire someone to replace

The rule an underwriter applies is simple: an adjustment survives if it can be documented and if the expense genuinely disappears under new ownership. Everything else is argument, and argument does not finance.

The financing floor

Below roughly $100,000 of SDE, third-party acquisition financing becomes difficult to obtain. There is not enough cash flow to cover a buyer's living expenses and debt service at the same time, so the buyer pool narrows to cash purchasers and heavy seller financing. Businesses in that range can be sold, but the price, the terms and the timeline all reflect it — which is another reason the earnings conversation should start years before the listing.

Alamo Brokers of Texas does not provide tax or legal advice. The material above is general and educational.