Thinking about buying a business? Thinking about selling a business?
No matter which side of the fence you are on, it is important for you to start by understanding the true range of value for the business. The market value of a small business can vary greatly from the book or tax mitigated value because most small businesses are managed to minimize taxable income. While this benefits the current owner, the cash flow will look less appealing to a potential buyer so it is important to perform a financial recast to calculate the true earnings of the business.
This recasting process will provide the buyers with an income amount more reflective of earnings. The easiest way to think about the recasting process is to consider this to be a way of demonstrating the financial results of the business “as if” it was owned by the buyer (taking into account tax-motivated or other discretionary transactions that reduce corporate earnings).
In this recasting process, an analyst will start from the beginning with the tax reported sales and expenses because any prospective buyer will want to be sure that the revenue and adjusted earnings that are stated ultimately tie-back to the tax returns. Then the analyst, with the help of the business owner, their CFO and/or accountant, will identify any discretionary expenses that are exclusively for the benefit of the business owner.
There are many legitimate tax-deductible expenses that are not necessary in order for the business to operate successfully. The most popular expenses, which would need to be recast, or “added-back” to calculate EBITDA (Earnings Before Interest Taxes Depreciation & Amorization) are:
1. Owner Salaries and Bonuses – normalize to one owner (if multiple) at FMV Salary
2. Rent of Facilities – is rent above or below Fair Market Value? – Normalize to FMV
3. One Time Professional Fees – non-recurring one-time related expenses
4. Other Income and Expenses – typically the dumping ground for expenses that cannot be coded elsewhere
5. Health Insurance Benefits, Life Insurance, Key-Man Insurance & Disability Policies for the Owner
6. Automobiles – are they needed for the business and/or do they cost FMV for what someone would actually need? (do you need a Ferrari or would a Taurus do?)
7. Consulting Fees – consulting fees paid to family, friends and/or advisors that would not be needed by a buyer
8. Discretionary Expenses – any discretionary travel, lodging, and entertainment expenses that are not directly related to business profits
9. Outside Investments – any funding provided by the business in support of outside, external ventures or property for which financial benefits flow to the owner
Basically, any expense that benefits the owner but is not needed for another owner to operate the company, should be added to EBITDA.
In addition to these Profit and Loss line items, there are also some Balance Sheet line items that may need to be adjusted in order to compare the business to industry standards. When adjusting the balance sheet consider items such as account receivables, inventory which is old/unsellable, shareholder assets/liabilities due, real estate not included in sale, and prepaid expenses.
As the seller it is important to have ample documentation to legitimize any add-backs because buyers will only accept adjustments that are credible and defendable. It should be expected that buyers and their advisors will do their due diligence and they will often request verification of journal entries so it is important to keep good records. There is a fine and very subjective line between legitimate and questionable recast adjustments and it is important not to include or present adjustments in a way that will negatively affect your credibility.
Ultimately, it is best to hire an experienced merger and acquisition advisor to advise you on the financial recasting process because this process can make a company substantially more compelling to buyers and as a result bring more value to the seller.
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