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for Companies with $500,000 to $50 Million in Revenue

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Seller Question #4: How Important are my Business Tax Returns?

“I make a lot more money than my tax return shows.”

If we only had a dollar for every time we’ve heard that!

Most business owners wage a constant battle between clean, accurate tax reporting and tax liability minimization. No one likes to pay taxes, so this struggle is understandable, and most business owners will focus on what costs them money today (paying taxes) rather than what makes them money in the future (selling a business).

If you ever plan to sell your business, there are some details about your tax return you need to pay special attention to if you want to not only maximize your business’ value, but also to make your business attractive and financeable. It’s not an exaggeration to say that the pennies you save today on your taxes will cost you dollars in the future when you decide to sell your business.

We’ve identified and discussed five important considerations business owners should make when deciding how to manage their financials and file their tax returns, an how those considerations can effect their business valuations.

Access to Acquisition Financing

Without question, the most critical role a seller’s business tax return plays in an acquisition is to help a buyer secure financing to purchase your company. The vast majority of transactions utilizing some sort of third-party lending source are going to rely on the business’ tax returns to justify that loan. Most lenders don’t even consider what your income statement says – they base their loan amounts and lending decisions off tax returns.

While your income statement will almost certainly be the financial report most buyers focus on because of the level of detail it offers about the business, the financing buyers need to buy your business is going to depend largely on your tax return.

With this said, don’t feel like you have to show a huge profit on the bottom line just so your business can qualify for acquisition financing when the time comes. The topics below discuss some things to keep in mind about what goes on your tax return and how to present it.

 

Start with EBITDA

Let’s start with EBITDA, which stands for “earnings before interest, taxes, depreciation and amortization.” EBITDA is a figure that represents the profitability of your business with non-cash expenses removed, such as depreciation. While this calculation is one of the most widely accepted and requested indicators of a business’ value, it becomes more relevant to business valuation as companies increase in size.

Regardless of your company’s size, though, EBITDA is important to understand because some these non-cash expenses can significantly lower your tax liability while not making impact on your business valuation.

For example, let’s say your tax return net profit is $250,000, while your tax return shows an interest expense of $50,000, depreciation of $100,000 and amortization of $10,000. As far as the IRS is concerned, you’re paying taxes on that $250,000 profit, but buyers are going to use your $410,000 EBITDA as a building block to determine your company’s value.

So don’t be discouraged or concerned if your net profit is lowered because of these types of non-cash expenses – they actually work in your favor all around.

Legitimate Owner's Expenses that Reduce Profit

EBITDA is easy – it’s all spelled out right there on the tax return for everyone to see and calculate. But there are some other expenses a company can incur that will have a similar impact on your taxes and business value. We call these “owner’s adjustments” or “seller’s discretionary expenses.”

These are expenses the business pays for, but while they may be expenses not uncommon for a business to incur, thee particular items are not really necessary to operate the business – at the end of the day, these expenses benefit the owner.

Some are very legitimate owner’s adjustments that the business covers, such as the owner’s salary, health insurance, life insurance or retirement contributions. Others may be a little less obvious discretionary expenses, such as sports tickets, club memberships or family vehicles. There may even be non-critical family members on the payroll, along with their benefits.

These are some examples of expenses that look legitimate on the surface, but when you really understand what they are and who they benefit, you realize they are not items the business needs to operate. So after we’ve calculated EBITDA, we add back these adjustments and discretionary expenses. This gives us a figure referred to as “seller’s discretionary earnings (SDE),” “cash flow” or “true owner’s net profit.” There are several terms for it, but they all mean the same thing.

At Least Make the Money Easy to Find

For some business owners, just the EBITDA items, owner’s adjustments and discretionary expenses aren’t enough. These owners run even more personal expenses through their companies’ books. While we don’t suggest doing that, if you choose to do so, at least make these items easy to identify and validate.

Some examples of what these might be include home improvements, personal hobbies or vacations – clearly personal expenses, but run through the business nonetheless. If you decide to expense items like these, don’t bury them in a way that they can’t be identified, because if you want to have a remote chance of getting credit for these items relative to your business value, you can’t be the only one who knows where they are.

We highly recommend avoiding having personal expenses like these included in your financials when you’re trying to sell your business, because the likely negative impact it will have far outweighs any positives. The old saying “cutting off your nose to spite your face” applies here, but instead it’s “saving your quarter to cost you dollars.”

Buyers' Confidence in your Business

The final critical point about your business’ tax return and its importance actually has nothing to do with revenue, expenses, add-backs or the business value calculation – it has to do with buyer perception of and confidence in your company and you.

A buyer’s confidence in your business, while it can’t be quantified, does impact the ultimate value that buyer will place on the company. One of the key drivers of buyer confidence is the quality of the financials. There could be two nearly identical businesses on the market at the same time – same industry, same geography, same reputation, same revenue and same margins – but one company has “clean” tax returns with easily identifiable and reasonable owner’s adjustments, while the other has significant amounts of personal expenses littering different categories.

Without question, the business with the clean tax return is going to sell for  higher price and have a better chance to qualify for financing, while the other business will struggle to find a buyer willing to pay close to what that company is really worth. Additionally, don’t discount the confidence buyers can potentially lose in you individually if they perceive your “funny” financials to be an indication of your honesty and ethics as a person.

Every business and owner is unique and certain circumstances will dictate how tax returns are compiled and reported, but these five points are important to consider, as we see them impacting values time after time. Whether you’re considering selling your business this year or in 10 years, it would be prudent to contact a reputable business broker, like Sigma Mergers & Acquisitions, today for a no cost, no obligation business valuation. This is a great way to examine your business’ value and identify strategies you might could implement on your tax return to ultimately increase your sale price.

If you have questions like these and what to discuss how the different answers impact the value of your business, please reach out to us and we’ll be happy to help. As always, one of the first steps in this process is to have us provide you with a no cost, no obligation business valuation.

Seller Question #3: What Responsibilities Will I Have After I Sell My Business?

Most business owners give a lot of thought to what they are going to do once they no longer own their companies. But with all the anticipation of retiring, traveling, spending more time with family, starting a new venture or simply slowing down, it’s easy to forget about what you’ll be doing immediately after the sale. All of those other dreams and goals have to wait – first you have to fulfill your post-sale obligations to the new owner.

As simple as you might think your business is today and as quickly as you think a new owner should be able to pick everything up, try and remember your first day in your business and how much you didn’t know or understand. Buyers interested in acquiring your company are going to want to ensure that you will provide whatever training and transition assistance they need to make the ownership change a smooth one.

What that training entails will depend on literally dozens of unique aspects of your business and the buyer, but below you will find some of the most important concepts to consider when thinking about how long you’ll be with your business after the sale and what you’ll be asked to do by the new owner.

Your Duties as the Owner

Buyers have to understand what you do, plain and simple. They need to know everything from what your day-to-day duties are all the way to what you might be responsible for doing only once a year. When buyers have a clear picture of exactly what shoes need to be filled after the sale, they can propose a transition and training plan that makes sense for them and ensures the business will not suffer.

Try to keep in mind the big picture here – whatever it is that you’re responsible for ultimately has to be taken over by someone else after the sale. So the more heavily involved you are in the business, the longer a buyer is probably going to want to you around to train and transition. In fact, there are instances where the owner is so irreplaceable that the buyer has no choice but to request that you stay on board for an extended period of time. There can also be scenarios where you “are” the business, and it makes it difficult for any buyer to imagine purchasing your company, period. With this in mind, as you start to give thought to the sale of your company, take some time to do an honest assessment of your involvement and duties. Then start to identify jobs you can delegate to other people within your organization. You may even discover a new hire is needed to make the business more efficient and attractive. Those types of adjustments will ease your post-sale obligations to the buyer.

Remaining with Your Company

It’s not uncommon for business owners to remain with their companies after they’ve sold them. This type of arrangement is more prevalent in larger businesses where the buyers tend to be private equity groups, investors and even industry buyers, as opposed to new owner-operators. Depending on your buyer, they might be planning to step in and assume your role, they might already have someone pegged to replace you or they may have no solution and need you to stay for a period of time. Many business owners will initially shy away from the idea of continuing to run their companies after the sale – what’s the point in selling it if you have to keep running it, right? But before you jump to that same conclusion, actually give some serious thought to what pains you about owning your business.

 

In the majority of cases like these, the things owners despise about running their companies are the very responsibilities the new ownership takes over. Things like insurance, financial reporting, managing cash flow and capital expenditures are examples of the responsibilities new ownership assumes, taking the day-to-day pressures of owning the business off your shoulders. So don’t dismiss the idea of continuing to work for the business after you sell it without really giving it some thought first. You may end up loving the opportunity to be an actual employee rather than the owner, and only worrying about your job instead of every tiny aspect of the business.

Operational Systems & Processes

Your business’ operations are yet another critical component a buyer needs to be comfortable with post-closing. Of all the aspects of your business that a buyer must manage after the sale, learning the operation should be the simplest and most straightforward. However, if the business owner hasn’t documented that operational process, then training can be a huge headache. Before you decide to sell your business, simply write everything down! Every aspect of your operational procedure needs to be detailed. Whether it’s as simple as how the business gets opened and closed every day, or as complex as how 100 delivery trucks get routed every morning, write it down and explain how those things happen.

Having this type of operational procedure on paper has a number of benefits to you, personally. The most obvious benefit is that it will make training a new owner significantly easier and more efficient. Additionally, if a buyer knows you have this type of documentation available, they will most likely request a shorter training period because they feel confident they can be trained quickly. Another added benefit to having transferrable procedures is that your business will be more attractive to potential buyers and ultimately more valuable.

Customer Retention

Customer transition is critically important to buyers. Once they understand the customers’ relationship with the business owner vs. the business, they will be able to better formulate a transition plan and explain what they need your help with after the sale. If you’re a business owner that has close, direct relationships with your customers and you are their primary point of contact, it wouldn’t be unreasonable for the new owner to request that you remain with the company for a period of time to help transition those relationships while still being involved with the business.

On the other side of that coin, if your duties with the business call for little or no involvement with the customers, then the new owner has less to be concerned about when it comes to customer transition and will most likely not ask for an extended period to help with those customers. This type or transition service is something you should expect to be included in the purchase price of your business and not a service you receive additional compensation for.

Employee Loyalty

Another major concern buyers have is employee retention – when you leave the business and they take over, will they have a problem retaining your employees? In most cases, your employees and the buyer want the same things – no changes. Buyers are typically concerned that once you leave the business after a sale that some of your employees may use that as an excuse or opportunity to look for another job and leave. On the other hand, it’s typically for employees to be highly concerned about keeping their jobs when they hear you’ve sold and a new owner is taking over.

The reality in the vast majority of cases is that the buyer doesn’t want to lose anyone and the employees don’t want to go anywhere. So how do you make everyone comfortable? In some cases buyers might ask for you to have your staff sign employment agreements prior to or after closing, they might ask that you agree to temporarily assume the duties of any key employee that leaves the business after closing, or they might even ask you to agree to assist with identifying and hiring replacements for any employees that leave the business within a certain time period after closing. You know your staff better than anyone, so you just need to have a plan to deal with any retention issues you think might occur.

What all of this post-closing discussion really boils down to is you taking a thorough and honest look at your organization and identifying where the true transitional risks are for a buyer. And once you know where those potential risks are, being willing to assist the new owner of your company for an adequate period of time after the sale to mitigate those risks and help ensure they are set on a path to successfully taking over your company.

If you have questions like these and what to discuss how the different answers impact the value of your business, please reach out to us and we’ll be happy to help. As always, one of the first steps in this process is to have us provide you with a no cost, no obligation business valuation.

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Sigma Mergers & Acquisitions LLC: 18170 Dallas Parkway, Suite 203, Dallas, Texas 75287
Dallas Business Broker, Mergers & Acquisitions Dallas / Fort Worth / Texas

214-396-8100 Office
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