It’s often a shock to most business owners when I tell them that paying the least amount of taxes possible might not always be in their best interest. And that shock is understandable. For many owners, they’ve spent years carefully managing their accounting practices to reduce their tax liability. But when it comes time to prepare their business for sale, those same years-old accounting practices might not be in their best interests. The relationship between tax strategy and the value of a business may not be intuitive, but is certainly worth exploring in more depth.
First, let’s discuss value. The vast majority of a business owner’s time should be focused on growing both your business and your personal income—and the two are usually directly related. Therefore, many owners find ways to reduce “on paper” business income by treating personal expenses as business expenses to lower tax bills. To this end, most business owners write off everything they possibly can. However, the final years before selling a business call for a change in strategy—because declaring as much income as possible can increase the price received in a sale. Let me explain.
Profitability and cash flow are the key drivers of a company’s value. Even buyers who utilize revenue multiples incorporate cash flow into their valuations. Simply put, more cash flow means a higher price.
When we prepare a company for sale at Caber Hill Advisors we will make certain adjustments to a seller’s financial statements in order to identify personal and one-time expenses that are not directly related to the operations of the business. This presents a clearer view of the buyer’s cash flow after the transaction. And it helps the buyer understand that the business generates more income than is shown on a tax return. Whether the income appears on the bottom line or is buried in expense line items, we will find it and add it to the net income to calculate adjusted cash flow (usually expressed as adjusted EBITDA).
This adjusted cash flow will become the basis for our valuation, but—and this is a huge but—it might not be the basis for valuations done by a buyer or lending institution. Certain add backs are obvious: interest, tax, depreciation, amortization, owner’s wages in excess of future compensation, and the lease of a company car. Investments in future growth, such as opening a new facility or headcount increases that incur salary before generating revenue, also receive this treatment. Some are a little gray but can be acceptable, like travel and meals and entertainment, especially if they are itemized in the general ledger detail and documentation supporting the add back is available. Other expenses that are buried within line items, however, can be much more difficult to justify. And when they are tough to justify—or appear hidden—buyers are less likely to accept them. If an owner is willing to mislead the IRS, why should a buyer believe they’re being honest with them?
When a buyer requires financing in order to complete the transaction, the bank’s valuation matters most. Lenders will require an independent accounting firm to either produce a valuation report or a quality of earnings report that supports the purchase price. In doing so, they independently calculate EBITDA and scrutinize each add back individually. Sellers must be able to clearly and objectively substantiate each add back in order to gain acceptance. By eliminating the personal expenses in the period immediately prior to a sale, an owner increases net income and reduces the risk of a deal falling apart during due diligence.
Many buyers value companies based on a multiple of cash flow, so aligning on the adjusted cash flow number is critical to convincing a buyer to accept your asking price. The one thing no buyer can ever dispute is net income, so by expanding net income owners eliminate many of these concerns.
Consider $100,000 in personal expenses that are buried in a variety of line items. By running this $100,000 through the business you probably save $30,000-$40,000 in taxes; however, if the buyer does not treat these expenses as add backs it could cost you $400,000 to $1,000,000 in purchase price. Think about it: pay an extra $30,000-$40,000 now and get it back 10-30x in the sale.
The extra taxes you pay in the final year or two before a sale could be the best investment you ever make.
