Discretionary earnings (DE) is a measure of the economic benefits to a buyer of a firm with goodwill. A buyer of such a firm has to be assured that there will be an adequate economic reward for bearing the responsibility of servicing the acquired customers,clients or patients (CCPs) (net of the cost of acquiring the firm). It is tempting to call these additional economic rewards “profit” or “free cash flow”. Profit and free cash flow are usually computed as the amount of income or cash remaining after all expenses (including owner compensation) have been subtracted from gross revenue. Often the economic benefit sought for in acquiring a firm with goodwill is additional compensation and not profit or free cash flow. DE provides a broader and more useful measure of economic reward.
Often it is difficult to distinguish between owner compensation and profits (which is what free cash flow is meant to measure) and the classification can be somewhat arbitrary. The classification of payments to an owner as wage or profit may be motivated by tax minimization considerations. In the case of C corporations, compensation often includes disguised profits. With S corporations, the opposite problem arises, with compensation often disguised as profit. No owner compensation is ever recognized for tax or GAAP (Generally Accepted Accounting Principles) purposes for proprietorships, partnerships, LLCs and LLPs. Because of these classification problems, business brokers use a metric known as Sellers Discretionary Earnings (“SDE”) or sometimes just Discretionary Earnings or (“DE”).
DE is a measure of all cash flows that a firm generates for its owner or owners whether they are classified as owner wages, distributions or profits. An emphasis is placed on the term “discretionary”. It is understood that there is an amount of expenses that must first be paid to third parties including all variable and fixed expenses in order to operate the business. Subtracting these non-discretionary expenses from total revenue leaves a fairly reliable measure of the economic benefits that are available to the owner. Using this DE measure is an effective way to eliminate some of the arbitrary tax motivated and GAAP classification issues just mentioned. For this reason I believe that DE is a good metric for measuring the required additional economic benefits required by buyers of small firms with goodwill.
DE is a relative and not absolute property of a small firm. DE will vary based on the degree of fixed overhead that the buyer will incur and the degree to which that buyer will provide services directly to CCPs. The general rules are: the higher the fixed expense burden the lower the DE, and the greater the degree of owner involvement in service provision the higher the DE. Potential buyers of different sizes will usually realize different DE rates from acquiring the same firm.
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Copyright 2018 Michael Sack Elmaleh