“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.
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.
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.
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.
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.”
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.