Getting Your Financial House in Order
In a business sale, the hardest barrier for the seller to overcome is often the ability to let go after 20/30/40 years in business. I’ve seen many more instances of Seller’s remorse than Buyer’s remorse in my handling of M&A. Yet even though business is humming and you’re ready to move on, the business may not be ready to be shown in the best light.
Just as you would stage a house for sale, a business should be staged. I’m not referring to cleaning the office when a potential buyer comes for a meeting (though you should do that too), but rather being able to show the true profitability of your operation. The more explanation it takes for a buyer to understand your financials and the higher amount of adjustments it takes to normalize your income, the higher probability that a buyer will discount your valuation. Think of it this way….if I don’t understand your financials or don’t believe an adjustment that you are making, I will perceive the endeavor as riskier. If I am willing to accept the risk, I will require a higher rate of return; hence offer a lower price.
Below are common issues that I consistently see when analyzing financials, though this list is certainly not comprehensive.
Multiple businesses units or locations with consolidated financials: I have seen a number of scenarios where a business owner has several franchises, multiple retail locations, multiple business divisions, or even disparate businesses all under one tax return and P&L. This is problematic when you are only selling one location, division, or franchise unit. Oftentimes, the revenue of each component is broken out, but the expenses are all lumped together. This makes it difficult to impossible to identify what percent of gross profit and cash flow is generated from each component of the business. If a buyer is unclear of the economics of what they are purchasing, it will be difficult to come up with an appropriate valuation and get through due diligence. Additionally, banks will have a difficult time underwriting loans, meaning sellers will likely receive less cash up front in their deal. In these instances, the minimum a seller should do is create separate P&Ls that are representative of the independent entities and divisions, noting how shared corporate overhead expenses are allocated. Depending on which issue above you’re solving, multiple business entities and tax returns should also be considered.
Not taking end of year inventory: Businesses with a large number of SKUs or several hundred thousand dollars in inventory know the pain. It’s difficult to close the business for the day or assign the team with the mundane task of counting everything in the warehouse. The problem arises that you lose the ability to accurately calculate your Cost of Goods Sold (COGS). Let’s suppose that you finished the year with $200,000 more inventory than you started. It’s normal for a business owner to use their purchases as the COGS number, but in this instance, you have overstated your COGS by $200,000 and understated your income by the same amount. Additionally, there is a higher likelihood that your COGS as a percentage of sales will swing. These false swings will cause confusions regarding both your pricing power and the strength of your vendor relationships. It also makes it difficult for both the business owner and buyer to understand the amount of working capital needed to operate the business. For business owners who don’t want to spend the time, there are inventory counting services who can handle your inventory counts for you.
Reclassifying expense items: It’s not uncommon to change CPA’s, bookkeepers, or decide on one’s own that one line item may be better classified somewhere else. I’ve seen scenarios where variable cost field labor is considered a cost of goods sold one year and included in salaries and wages in future years. One’s CPA can be classified under professional services or accounting. You may break out worker’s comp insurance as a separate line item from your liability insurance in one return and consolidate them as a single insurance line item the following year. Any one reclassification can usually be easily explained and is not cause for concern. However, multiple changes year after year may ultimately require the hiring of a forensic accountant to unwind the confusion, which can be costly. Additionally, multiple changes will raise a red flag. Consider what a buyer will think…if you don’t pay attention to managing one of the most important aspects of your business, what else are you failing to pay attention to?
Personal expenses run through business: It’s a common saying with a wink and a nod… “I have certain benefits as a business owner in addition to my income.” While tax avoidance or deferral are legitimate methods to reduce ones tax liability and improve cash flow, tax evasion is another story. Personal expenses such as one’s Mercedes lease, travel and entertainment expenses, or child on the payroll that does not work in the business, may all seem like easy things to explain to a buyer. However, consider what a buyer will think when you begin the discussion about how your personal expenses will go away once they own the business…. “You’re okay being dishonest with the IRS when it benefits you financially. Now, you’re asking me to take your word for something when we’re entering into a negotiation that will benefit you financially.” In addition to the concern this brings to the buyer, banks that are often the source of capital for business transactions will usually not give you credit for these types of expenses. This could create a situation where the price is lowered or you are asked to carry a larger promissory note. For my normal disclaimer, please recognize that there are times you can have the best of both worlds. You may be able to justify financial adjustments that benefit your taxes in the short run and your sale in the long run. However, there are many instances that you may save 30 cents on the dollar in the near term, only to give up $3 for every dollar of incremental profit on the backend. Make sure you are working with your CPA and M&A advisor to understand which category your discretionary items fall into.
Lack of a Balance Sheet: Just because your P&L shows net income, it does not mean that you are making money. That’s right, your balance sheet tells a story too. For example, your business is on cash accounting, meaning that you recognize income when the cash is received. You have $500,000 in accounts receivable that should have been paid in December 2013. However, the client did not pay you until February 2014. During 2014, your business truly operated at a loss of $250,000, however when you add in $500,000 of cash received, it appears you made $250,000. Let’s consider a scenario that makes your financials look worse on the surface….you have a huge tax bill coming, so you pre-pay expenses for the following year. In that instance, the business will look less profitable than it should. These types of items can only be seen and understood when you keep an accurate balance sheet.
Remember that buyers are typically looking at 3 years of financial statements, as are the banks who are lending money. When you’re thinking about going to market, give yourself three years to get your financial house in order.