As you read in part one of selling a business: what is your business worth, a seller’s price expectation needs to be in line with market reality. Most financial statements of small businesses are prepared to minimize the tax burden for the company and its owners. To reflect the company’s true earnings, we need to recast/normalize the balance sheet and income (profit and loss) statement.
In a small to medium-sized business, owner’s compensation is often based on what the business can afford. It tends to be the area of biggest adjustment in an income statement, where we “add back” expenses considered discretionary, extraordinary, non-recurring or non-cash.
We also add back interest as the new owner may have a different capital structure.
Owner’s compensation can include pension plans, profit sharing, health and life insurance, auto travel, entertainment, meals, memberships, dues, fees, subscriptions, salary, wages, bonus and payroll taxes, family and relatives on payroll.
In recasting, you need to ask: Will the new owner incur this expense to obtain these earnings? This process can take some time and requires the business broker/appraiser to have the right questions.
A recasting example
Let’s look at an example of an auto service centre – Andy’s Auto Service – recast to uncover true earnings (Sellers Discretionary Earnings/SDE*). The company’s income statement shows gross profit is $300,000, based on revenues of $750,000 and cost of sales of $450,000. After subtracting operating expenses of $298,000 the company’s pre-tax profit is $2,000. Would that interest a buyer?
*SDE is net income less: interest; taxes; depreciation and amortization; owner’s compensation (including salary and discretionary expenditures.
With recasting, operating expenses were normalized to $107,500. It’s not that certain expenses aren’t legitimate-it’s whether or not they’re essential for the next owner. Sometimes, we need to add back discretionary expenses that an owner hasn’t included – a family member who works for no pay, an owner who uses his own tools, unrecognized expenses, or where a business is uninsured or under-insured.
In our example, the true earnings were determined to be $109,500, proportionately more in line with the 15 to 25 percent of gross sales that SDE typically represents in a small (four to six-bay) auto service centre.
The EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization in this example is $59,500, as we would have to add back the cost of a replacement for the owner at a fair market wage estimated at $60,000.
Recasting the balance sheet
We also need to normalize assets and liabilities.
The recast balance sheet should reflect the Fair Market Value (FMV) of the assets and liabilities being transferred.
While net book value is used for tax purposes, their value as is, in use, in place, is more relevant here for tangible assets such as furniture, leasehold improvements, vehicles, machinery, etc. Intangible assets– goodwill, patents, trademarks, database/mailing lists, licenses, permits, franchise agreements – should also be recast to FMV.
Only after we have done this recasting can we 1) look at industry benchmarks to analyze performance against similar businesses, 2) identify the value drivers and 3) begin the process of valuing Andy’s business.
For recasting, we need the financial statements as prepared and filed for the past three to five years. We also need the owner’s time and substantiation for our adjustments, which we document with source, rationale and supporting paperwork. All will be required at due diligence.
Back to our Auto Service Centre – after recasting we have a business with SDE of $109,500 and equipment worth $148,000 rather than the book value of $73,000 and inventory worth $43,000. We now have a saleable business operating with the industry norms for its type and size.
Many more factors
There is much more to take into account. Does the year-end represent the normal level of inventory? The value of the inventory is a topic on its own the method of accounting used and its proper application affects the cost of sales, and of course, the earnings.
The operating and accounting systems, employee training and loyalty programs, marketing collateral and programs, customer retention, applicable gross margins and pricing systems, mix of commercial and consumer work, location and factors affecting future market growth, availability of good employees, competition and differentiators, niche focus of the service centre, etc., all effect the value and saleability of the business.
The structure of the sale and the willingness of the owner to finance some of the purchase price are other major factors.
Having the valuation done early will give the owner time to work on tax planning and increasing the value of the business before sale.
We take a closer look at structuring the sale to be tax efficient in Minimizing Taxes When You Sell.