A critical step when selling a company is to recast financial statements. Once a business owner has decided to sell their company, it is important to hire an experienced mergers and acquisitions firm that can provide an accurate valuation for that business. Typically, financials statements are prepared by business owners to minimize their tax liabilities, not to sell their company. Sellers will come to the realization that over the years working with their accountants to decrease their taxable income, which is perfectly legal and understandable, has now diminished the valuation of the company when they try to sell. While minimizing their tax liability is the goal of most business owners, unfortunately, this illustrates a misleading picture when it comes time to demonstrate the true profitability of the company to prospective buyers.
It is vital for buyers to recognize the full potential and income producing capabilities of the company that they are purchasing. Since net income or earnings before interest, taxes, depreciation and amortization (EBITDA) is the main variable when assessing a business, hiring a business broker that can recast financial statements to maximize company valuation and show future growth by clearly defining owner benefits and removing one-time or non-recurring extraordinary expenses is imperative. Before going to market, adjusting the financials will give buyers a more accurate picture of how much revenue the company is truly capable of producing. If a company overlooks recasting their financial statements correctly, they will ultimately be undervaluing their business and leaving money on the table.
Recasting financial statements is an accepted principle by which expenses (or revenues) that are unrelated to future business operations are removed and adjusted. As stated earlier, most business owners try to reduce their bottom-line income as much as legally possible, in order to reduce their annual tax bill to uncle Sam. While this is advantageous in the short term, when a company owner goes to sell, they will realize their net income doesn’t look as attractive to buyers as it could. The process of recasting financial statements is perfectly legal by presenting specific and identifiable adjustments to company profit and loss (P&L) statements usually from the past 3 to 5 years. Recasting is common practice because professional buyers are purchasing the future performance of the company, not the past.
Professional buyers, especially capital firms or institutions, are typically evaluating multiple companies and opportunities at the same time. It is important to recast financial statements because these experienced buyers are comparing earnings from several businesses to assess which opportunity will be the most lucrative or best deal. For this reason, recasting financial statements is an essential tool that M&A firms use to help those buyers determine an accurate valuation for a company and also how much a bank would be willing to lend if they borrow money to purchase. Keep in mind when recasting financial statements that this should be accomplished through a professional since this process can take a considerable amount of time and if done incorrectly, can lead to a deal falling apart by providing misinformation or inaccurate EBITDA.
Traditional Recasting Adjustments
The traditional financial recasting adjustments include owner salaries and benefits, non-cash expenses, interest and non-recurring income or expenses.
Usually, the most significant financial recasting adjustment involves the salaries and bonuses the owner withdraws from the company. Since salaries are entirely discretionary, some business owners take enormous salaries and bonuses that are not necessary to continue operating the company and therefore, the new buyer will not have to continue paying those expenses in the future. When recasting financial statements, the salary of the primary owner is added back and if there are multiple owners receiving salaries, the decision needs to be made whether those additional roles are required to continue running the company.
For example, there are 3 absentee owners who draw salaries and bonuses but they only spend a few hours working each week. If the owner responsibilities could easily be completed by one person, all 3 salaries could be added back. Alternatively, if 2 of those owners spend 35+ hours a week working, then those 2 owners’ salaries would need to be “normalized” (simply stated, the cost of hiring 2 more employees to fulfil those roles). One owner’s salary could be added back but for the other 2 owners who work 35+ hours per week, the buyer would have to replace them with employees. For instance, those 2 owners withdraw $100K salary each but the true cost at market rate for 2 additional employees to fulfil same roles is only $60K each - this add back would be $80K ($200K vs $120K normalized). This could increase valuation anywhere from $240K to $400K (3x - 5x multiple).
The next biggest financial recasting adjustment includes the owner’s benefits or incentives. Again, most business owners receive benefits that are not required to operate the company. These benefits or “expenses” include personal car insurance, personal health insurance, 401K or retirement account contributions, meals and entertainment, travel and personal accounting or legal services paid by the business. For example, a business owner may expense the cost of a company leased vehicle but the monthly price of a Honda compared to Lamborghini is a big difference.
Non-cash expenses and interest are the obvious financial statement adjustments. Since buyers determine true valuation of a company based on EBITDA, non-cash expenses such as depreciation and amortization are added back. In addition, most business deals are purchased debt free and clear of any interest-bearing liabilities, so interest will be added back as well.
Extraordinary, non-operating and one-time expenses are adjusted as these are uncommon or unrelated to normal company operations. Any expenses that the buyer will likely not have to continue after the purchase of the business are adjusted. These include one-time legal expenses, moving costs, equipment lease payments, extraordinary bonuses to employees, charitable donations and unusual marketing expenditures. Any rent payment above or below market rate should be normalized and adjusted to give the buyer an accurate picture of true rent expense for the future.
Recasting financial statements is a crucial step when selling a company. Most business owners reduce bottom-line income to minimize their tax liability, so it’s important to hire an experienced M&A advisor that can recast financial statements to maximize the valuation for that company. Before going to market, adjusting the financials will give buyers a more accurate representation of how much EBITDA a company is truly capable of producing. Buyers will have an exhaustive due diligence period and sellers need to be prepared to clarify the addbacks. A qualified M&A advisor that exclusively represents sell-side M&A deals can explain to sellers which category adjustments and how much can legally be added back in order to make a company look the most attractive in the marketplace.
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