by Dave Driscoll
No business owner enjoys sending 40% of their hard-earned cash to the government, which has contributed no equity to the business, produced no revenue, and created additional administrative costs for the company. However, the requirement to pay taxes isn’t going away.
Most business owners seek legal ways to reduce the impact of their taxes. While doing so is a legitimate strategy, it’s also critical to keep track of expenditures that reduce your taxes. The inability to identify “discretionary expenditures” will come back to haunt you later when you want to maximize proceeds from the sale of your business.
Business valuations are based on historical earnings. If a business shows no earnings, that business is worth little more than the liquidation value of its assets, so maintaining accurate records to reconstruct the company’s cash flow is critical to maximizing the eventual selling price.
To help determine the asking price, business brokers review three to five years of financials with the intent of “normalizing” the cash flow produced by the business. Normalizing is the process of adding back - or increasing - earnings based on the owner’s discretionary expenses (i.e., adding back the owner’s “tax minimization strategies”).
Legally minimizing your tax bill is not a problem. However, you do need to track all those strategies in a detailed listing of accounts and amounts of discretionary expenditures. Such documentation will help your business broker determine accurate cash flow which, in turn, will help you to appropriately price your business.
Businesses that handle cash often debate whether to record cash sales. Not recording cash sales gives an owner the immediacy of cash without paying taxes. However, in the process, he or she is also not recording revenue to offset the expenses of the sale, thereby producing a loss on that sale.
Without a road map of actual sales and discretionary expenses, the business valuation will likely miss critical cash flow to establish an accurate business value. Such omissions could dramatically impact the asking price for the business.
Some companies report the financial operating results on an internal book basis reflecting the results of normal operations and noting “owner’s discretionary expenses” below operating income. This strategy produces a true picture of the cash flow created by the business before tax minimization strategies. At tax time, the accountant adjusts the internal book reports to tax reporting that reflects all the legitimate adjustments to income to calculate the business’s tax liability.
Business value is primarily about earnings, and potential buyers expect historical evidence of those earnings. Without an ability to demonstrate the actual discretionary cash flow produced by the business, supporting an appropriate asking price is very difficult.
My advice is to document discretionary/tax minimization strategies reflected in your operating statements for at least three years prior to beginning the process of selling your business. Without these records, you will be unable to prove your historical earnings, and the value of your business will suffer when you are expecting a reflection of your years of hard work. You can only sell the cash flow you can prove.
Dave Driscoll is president of Metro Business Advisors, a business brokerage, valuation and exit planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at DDriscoll@MetroBusinessAdvisors.com or 314-303-5600. For more information, visit www.MetroBusinessAdvisors.com.