Since it's tax day, I figured it would be appropriate to dust off an old article about the relationship between tax strategy and the value of a small business.
The vast majority of your time spent as a business owner should be focused on growing both your business and your personal income, and the two are usually directly related. Therefore, finding ways to reduce your "on paper" business income by treating personal expenses as business expenses lowers your tax bill and helps accomplish this objective. To this end, most small business owners write off everything they possibly can; however, the final years before selling the business call for a change in strategy, because declaring as much income as possible can increase the price you receive 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 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 in order to present a clearer view of the buyer's cash flow after the sale. This helps the buyer understand that the business generates more income than is shown on the 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.
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, and the lease of a company car. Some are a little gray but can be acceptable, like travel and a personal cell phone, especially if they are itemized on the P&L. Other expenses that are buried within line items, however, can be much more difficult to justify. And when they are tough to justify and/or appear hidden, buyers are less likely to accept them. If you are willing to mislead the IRS, why should a buyer believe that you are being honest with them?
When a buyer requires financing in order to complete the deal, the bank's valuation matters most. Banks, especially the SBA lenders most commonly used in small company transactions, will not accept many of these add backs; they usually agree with the obvious add backs but may negate the rest altogether. So, by eliminating the personal expenses you increase net income and make your business more attractive to buyers and lenders alike.
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 your net income you eliminate many of these concerns.
Consider $10,000 in personal expenses that are buried in a variety of line items. By running this $10,000 through the business you probably save $3,000-4,000 in taxes; however, if the buyer does not treat these expenses as add backs it could cost you $30,000 to $70,000 in purchase price. Think about it: pay an extra $3,000-4,000 now and get it back 10-20x 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!