To Sell Your Business, Clean up the Books!

Today's discussion is going to be about some ways that you can increase the

value of your business and also make it more attractive to potential buyers. We're going to be focusing on smaller businesses today. I am talking about any business with EBITDA of less than $1.5M. Once you get above that, you start dealing a little bit more with private equity firms and that's a different discussion which I cover in a separate article. So what we’re really talking about here is owner-operated businesses.

First off, when trying to make your business more valuable for a potential buyer, the more planning you can do the better. For valuing a specific business, I would need specific information on that business. However, a lot of the factors that buyers use in valuing small businesses are the same across virtually every industry. So, no matter what type of small business you have, there is a good chance that most of what I am talking about is going to apply to your business.

The first thing that you need to do in order to increase the value of your business and make it more sellable is deal with your financial statements. Clean those up! In a business acquisition, there's nothing more important than the numbers. If you can't get a buyer interested and excited about the numbers, and explain them in a way that a buyer is going to understand, then the rest of the issues are not going to matter.

Most sellers keep financial records for the purpose of filing their yearly tax returns. The problem with this is that the goal is usually to pay as little tax as possible, so their tax returns maximize expenses and minimize revenues. Many sellers also run personal expenses through the business, and worst of all, in some cases, they fail to report a portion of revenues altogether. Each of these issues presents a challenge when the owner gets ready to sell the business, but most of them can be overcome with a little advance planning.

When a buyer wants to review your business tax returns, a lot of the issues above can be addressed through “add backs”. An add back is essentially an item or amount you “add back” into the Seller’s Discretionary Earnings Number. For example, let’s say I have a manufacturing business and my tax return shows taxable income of $300,000. We are going to take that $300,000 and modify it to reflect the true value of the business to the owner.

Because EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, we need to add back those 4 categories using some hypothetical numbers. One note on taxes; we are only talking about income taxes, not payroll, property or any other taxes. Let’s assume we had $5,000 in interest expense, $20,000 in taxes, $6,000 in depreciation, and $3,200 in amortization

Then we look at what other benefits I, as owner, received from the business. I paid myself a salary ($75,000) and paid my personal health insurance ($24,000), car note ($7,200), and golf club membership ($15,000) through the business. We are looking for anything paid out through the business that the new owner will not continue to pay to run the business. In addition to the things above, we are looking for one time or extraordinary business expenses the new owner will not have to pay. A good example of this is a lawsuit settlement. So, let’s assume I settled a lawsuit against my company for $27,000 last year and it is related to an issue that is unlikely to arise again.

Now in order to get the net benefit to owner number, also know as or Seller’s Discretionary Earnings, we have to add all these items to the taxable income. In this case that would look like this:

Taxable income: $300,000

Add Backs:

Interest $5,000

Taxes $20,000

Depreciation $6,000

Amortization $3,200

Salary $75,000

Health Ins. $24,000

Car Note $7,200

Golf Club Membership $15,000

One Time Legal Exp. $27,000

$182,400

Total SDE= $482,400

A business normally sells for some multiple of SDE. While that number will vary depending on a number of factors, for a business this size, 3.25x SDE would not be unusual. Given that a business of this size might see a sales price of 3.25x SDE, the add backs have increased the business value by $592,800 ($182,400 x 3.25). Keep in mind however, that the more add backs you have the harder it may be to get the buyer, and more importantly, their bank, to accept all of them. Almost all deals involve some type of financing and therefore require lender approval.

One add back I can promise you that a bank will NOT accept is unreported revenue. In the scenario above let’s assume the business earned total revenues of $1,000,000. That means it claimed expenses and deductions in the amount of $700,000 to get that $300,000 taxable income number I used before. If they had not reported $100,000 of that income (and assuming all deductions and expenses were still reported the same way) then their taxable income would have been only $200,000 ($900,000- $700,000). That would have led to an SDE number of $382,000.

Not reporting that $100,000 likely saved the company and/or its owner somewhere in the neighborhood of $30,000 in taxes. BUT remember the SDE multiple I used above was 3.25x. So by reducing the SDE of the business by $100,000, the seller has lost $325,000 on the sale value! That’s almost $10 lost for every $1 saved on taxes!

So, if you take nothing else away from this article remember that when you are thinking about selling your business you want to make sure you report all possible revenue and that you remove as much as you can that has little or nothing to do with the business; for example, the golf club fees and the personal car note. Most of the other stuff like health insurance and salary, people are used to seeing so that's not a problem.

Buyers want to see a business that is on the way up. For example, a business that made $100,000 in 2021, $150 000 in 2022 and is on pace to make $250,000 in 2023. The good news is that even if your business has been relatively flat from a revenue standpoint, there are ways to restructure the presentation of your financial statements to show the business in the best possible light.

One final thing to look at on your financial statements is contingent liabilities. You will want to wipe out whatever contingent liabilities you can. I have seen so many deals fall apart because of this. A contingent liability can be a lot of things, but it is usually some type of dispute such as a civil lawsuit or potential fines, fees and/or penalties with some type of regulatory agency like the I.R.S.

For example, let’s say you've got a former employee that is suing you for one million dollars and it's a fairly frivolous lawsuit. Maybe it's got some nuisance value but that's about it. So you're going to want to try to settle that before you list your business or shortly after you list it because nobody wants to buy a lawsuit. Even if you know that the suit is frivolous, the buyer does not. Not only that but if you list the business and need that lawsuit to go away right before the closing, then that former employee will hold a lot of leverage in that situation.

Jeff Brown is a Business Broker with Business Acquisitions, Ltd. in Denver, CO. He is also a former M&A Attorney and Entrepreneur who has owned, operated and sold five successful businesses of his own. Jeff can be reached at 720-989-4121 or Jbrown@Baltd.com.