We all know the drudgery of cleaning something significant to get it ready to sell, whether a business, a house or even a car. You want whatever you are selling to look its best for possible buyers and, ironically, better than you ever cared to have it looking for yourself. In many ways, a business is no different. After working so hard to nurture a business from start-up to success, the owner knows the business better than anyone, and has gained a high level of comfort with how it looks. A collection of bank statements and receipts, distilled annually into a reasonably-accurate tax return, may be sufficient for the owner, or at least until the owner needs a loan for additional working capital to grow the business. Prospective buyers will not have the same level of comfort as the selling owner, and a high-quality business should present high quality financial statements.
It does not take long selling businesses to come across the so-called “cash” business – so called because not all the cash receipts make it into a cash register or bank account. There are no financial statements, and the tax returns will not reflect the true revenues of the business. Aside from the tax consequences, from an economic perspective this is not a wise business tactic for the business owner contemplating sale within a few years. Most business buyers are savvy enough not to accept the seller’s claim that a business generates revenues greater than what he is reporting on his tax return. The buyer will not pay for unreported revenues, and thus will offer less for a business showing lesser revenues. Take for example a business with $100,000 unreported cash receipts, and consider that a buyer might be willing to pay 2.5 times average earnings. Failure to report the $100,000 cash receipts will cost the business owner $250,000 in sale price, since the $100,000 unreported revenue would all fall to earnings, assuming that all business-related expenses had been reported. (Failure to report expenses is not very often an issue, but can be – for example, cash payments to undocumented employees.) If the business owner is in a 40% tax bracket, he will pay $40,000 less in taxes having not reported the additional revenues. It would be short-sighted for the owner contemplating a sale to “save” $40,000 in taxes and lose $250,000 on the sale. Ensure that the revenues of the business are accurately reflected and reported in both financial statements and tax returns, to increase business value (and for restful sleep when the audit notice arrives).
On the expense side of the ledger, there are many typical expenses that are discretionary to the business owner, yet fully legitimate to deduct for tax purposes. Discretionary expenses are simply those expenses that are not absolutely necessary to run the business, but payable and deductible in the owner’s discretion. The clearest example is owner compensation, which the owner can pay to herself or retain in the business, in her discretion. Related to owner compensation are other owner benefits, such as automobile payments, personal insurance coverages, and certain travel expenses or industry events. It might be good for the business that the owner attends that trade conference in Honolulu, but maybe not absolutely necessary to run the business. A common exercise for the business broker in any engagement is to analyze the financial statements and tax returns to determine any discretionary business expenses, which are then added back to taxable income, along with certain other non-cash or financing charges, to determine discretionary earnings.
The key for a business owner desiring to clean up the financial statements is not necessarily to eliminate discretionary business expenses. Those that are typical and easily understood, including those described above, are simply analyzed and explained to a buyer. However, other discretionary expenditures that are maybe less directly related to the business may be more difficult to segregate and explain. For example, the $5,000 in office supplies that end up at the owner’s home will be difficult to recover in preparing the business for sale, costing 2-3 times as much in lost sale price. The result is no different than failure to report revenues – the tax savings of taking those deductions now will disproportionately impact business value when it is time to sell. Significant expenditures that are capital in nature should be booked and depreciated, not buried in expenses. Our advice to an owner preparing to sell within a few years is simply to tighten up on expenses, ensuring that they are either clearly related to the business (i.e., the eventual buyer should expect the same expenses to run it), or can be clearly explained and documented as discretionary to the owner.
As to the quality of financial statements presented, most businesses do not need audited or even reviewed financial statements prepared by a CPA, although these are certainly appropriate as a business grows. Typically, the lenders are the ones to determine when a higher-level verification of financial reporting is needed. However, obtaining compiled financial statements prepared by an outside CPA firm is a relatively inexpensive step to take, and well worth the expense when the owner prepares to sell. Whether justified or not, many buyers will place a greater value on the financial statements that have been compiled and professionally presented by a knowledgeable CPA. This is particularly important if the business owner does not have the knowledge or skills to do this himself, as inconsistent or poorly-presented financial statements will undermine the buyer’s confidence in what they are buying. High-quality financial statements have the opposite effect, inspiring confidence in the buyer and hopefully minimizing issues that could arise during due diligence. Further, it will be a great value to have available during due diligence a CPA who knows the business well and can easily answer buyer questions, which further inspires buyer confidence. Professional financial statements may not justify a higher asking price, but it is our experience that they are often worth their weight in gold in ensuring that buyers maintain confidence in the quality of the business and that deals stay on track to closing.
Finally, just a few words on the balance sheet. Typically, the value of a profitable business will be determined based on its future earnings potential. The assets that are necessary to generate those earnings, including FF&E, inventory and goodwill, must be included in the sale transaction and pricing to generate the earnings, meaning that they do not have independent value aside from the earnings potential of the business. As an example, if a business generating $250,000 in earnings is valued at $800,000 based on its earning capacity, the value of the inventory or equipment of the business will not normally increase its value. A business requiring less equipment or inventory and generating the same earnings is not less valuable, it is simply a more profitable business in proportion to invested capital. So while all productive, operating assets of the business must be included in a sale transaction, any non-productive assets can be (and should be) sold, turned into cash, and removed from the balance sheet, prior to marketing the business for sale. Examples include machinery no longer used in production, unnecessary vehicles, excess levels of inventory, and assets that are used personally by the owner, such as the condominium at the beach. A prospective buyer might object to certain of these assets being excluded from the sale transaction, or to decreasing inventory levels, but if removed well in advance of a sale transaction the assets will not be missed by the business. Accounts receivable is often excluded from a sale transaction since it is not a productive asset, but cleaning up bad accounts well in advance of sale will improve the marketability of the business.
Financial housecleaning may not be exciting, but it is certainly an important step in preparing a business for sale. Improving the financial statements and tax returns of the business well in advance of marketing the business pays dividends when it comes time to sell.