Since the price a business owner receives when he sells his business is directly proportional to the earnings, it is in the owner's best interest to recast the earnings to industry standards to make sure he is maximizing the sale price. The higher the amount of recast earnings, the higher the sale price will be. Brokers and accountants will recast the earnings for the most recent 3 to 5 years and brokers present this information to prospective buyers. Those buyers will base their opinions of value on many factors, but the most important by far is recast earnings. After an agreement has been negotiated between the seller and the buyer, the earnings will be verified by the buyer and his accountant. This verification is called "financial due diligence".
There are several industry standards for presenting earnings: Sellers Discretionary Earnings (SDE), Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), Free Cash Flow (FCF) or other variants of earnings. In middle market businesses buyers may look at all of these types of recast earnings while in very small "Main Street" businesses SDE is the standard.
All of these earnings standards have one thing in common: a broker or accountant makes adjustments to earnings such that the resulting "recast earnings" conform to the industry standard definition and represent the earning power of the business in a comparable way. The theory is that, all things being equal, the buyer should enjoy earnings similar to the recast earnings after he takes over the business.
The definition for SDE is: "Earnings before taxes, interest, depreciation and amortization plus discretionary expenses, eliminating non-recurring income and expenses, and adding back all compensation to all working owners in any form, less compensation at industry standard rates to replace all except the top working owner with non-owner employees". This is the most common earnings standard used when selling small businesses that are owner operated.
The definition of EBITDA is: "Earnings before taxes, interest, depreciation and amortization plus discretionary expenses, excluding non-recurring income and expenses, and adding back all compensation to all working owners less the industry standard compensation for non-owner employees to replace all of them". EBITDA is important when the buyer is an entity such as a corporation or an investor group because the corporation or investor group obviously can't be the top manager - it will need to hire one at industry standard compensation. Therefore, after adding back all of the top owner's compensation as in SDE, a negative adjustment is made to subtract the industry standard compensation for the top manager.
The definition of Free Cash Flow is: "Operating cash flow minus capital equipment expenditures". FCF is commonly used for capital equipment-heavy businesses. In the beginning of the sale process the broker or accountant will recast the earnings. Some recasting adjustments are obvious: interest, depreciation, amortization, owners" compensation. Not so obvious are discretionary and non-recurring income & expenses, and owner "perks". These items are added back to earnings under the theory that a new owner won't have these expenses, so all other things being equal, the earnings going forward should be greater by the amount of these items. The broker or accountant probably won't recognize these items without input from the business owner. The resulting SDE (or EBITDA) is then used to calculate a sale price for the business. Since businesses often sell for multiples of earnings, each dollar added back adds a multiple amount to the calculated sale price. Multiples used to value businesses come from sales of comparable businesses.
So what is the point? If you as a seller are following everything up to this point, then we can get to the main issue about due diligence: the seller must be willing and able to produce documents to satisfy the buyer's accountant that the adjustments are not going to be ongoing expenses for the buyer after the buyer takes over the business, and therefore are legitimate addbacks. These documents usually include everything, right down to the individual receipts for each transaction, airline reservations, hotel receipts, meal receipts with names of the parties, ground transportation receipts, etc. Credit card statements or check registers alone won't satisfy the accountant.
Where does the trouble start? Usually, the trouble starts in listing the business for sale when a broker or accountant who is eager to justify the highest possible price for the seller, adds back discretionary expenses, non-recurring expenses or perks that the seller can't (or won't) produce documents to verify. For example, suppose that the broker is asking the seller: "How much of your company's travel and entertainment expenses were strictly personal benefits, unrelated to business?" The seller answers that it was about $35,000. So the broker adds $35,000 back to net operating income along with interest, depreciation, amortization and owner's W-2 compensation. This recast income figure is then used to price the business for sale.
Next, the seller accepts an offer and the buyer's accountant requests documentation to verify all of the addbacks. The seller balks and refuses to provide the receipts, such as airline ticket reservations, etc. and a signed narrative stating the purpose of each trip along with a statement that there was no related business purpose. Why? Perhaps the seller might be concerned that this information might find its way to the IRS. In over 5,600 business sales, we've never heard of anyone getting in trouble with the IRS over this issue. Or, in the worst case, these really were legitimate business expenses that the buyer will incur if he is to keep the business revenues and earnings at the same level as the seller - the entertainment, meals and travel expenses might actually be business development expenses for entertaining key managers or staff in customers' companies so that they will refer business to the seller. The broker should not have added these items back and therefore, has overstated the earnings of the business.
Lesson to sellers and brokers in recasting: don't add back anything in the beginning of the business sale process that the seller is unable or unwilling to verify to the buyer's accountant later in the due diligence process. It is probably better to sell for the market price based on the earnings you are willing and able to prove, than to represent a higher earnings figure to get a higher price, and see the deal fail because you can't or won't prove some of the addbacks. This sort of situation usually causes the buyer to lose trust in the seller (and the broker) then withdraw rather than re-negotiating the price and terms. Other times, rather than terminating the purchase, buyers negotiate to reduce the price or to use a variable price dependent on future business performance for part of the payment to the seller, since the seller couldn't prove the addbacks.
Stated positively: When you list your business for sale, only add back items that you are willing and able to prove to the buyer's accountant in the due diligence process. Then you can successfully complete financial due diligence, complete the sale and enjoy the profits.
If you have two years before you plan to sell: Stop writing off personal expenses as business expenses for at least two years before a sale. Buyers and bank loan underwriters only rely mainly on tax returns, so you must file at least two clean tax returns to enable the business to qualify for financing and to convince buyers of the higher price justified by the higher reported earnings that can be proven without attempting to add back a lot of personal expenses that were written off as business expenses. It will also give you credibility in the eyes of the buyer and his accountant to know that verifying the earnings shows a "clean" operation.
About The Author: Greg Carpenter, Business Broker in the San Francisco Bay Area since 1985 completed sale of more than 350 businesses including manufacturing, distribution, transportation, staffing, education, restaurant, catering, automotive services and retail. Appraisal of businesses for litigation support including appraisal reports. Greg can be reached direct at 408-385-6658 or 408-898-0393.
Categories: BizBen Blog Contributor, Due Diligence Issues, How To Sell A Business, Selling A Business
Comments Regarding This Blog Post
Greg makes excellent points!
And, the message is really to the seller: Prepare all the likely due diligence items in advance so that when you do go into contract you can complete due diligence in a matter of days. Time kills deals. And, the longer it takes for the buyer to get information from the seller, the more likely that the deal will fall through.
Contributor: Transactional Attorney
This is excellent information, and a point that all sellers should consider carefully before they list a business for sale. In addition to potentially killing a deal in due diligence, overstating "provable" add backs can potentially open up legal issues after the sale.
If a seller represents that the business has Seller Discretionary Earnings of $X, they may potentially be liable if that doesn't turn out to be true-- even if they have given the buyer access to the books and records in due diligence.
For example, clauses in a purchase agreement that require a buyer to review the books and records to their satisfaction won't necessarily protect a seller from claims for intentional misrepresentation.
If it's not realistic to stop writing off personal expenses before you sell your business, at the very least keep detailed records and all receipts so you can prove those expenses are truly "discretionary" when the time comes.
Contributor: Business Appraisals, Valuations Advisor
A great article. There are capital intense businesses where their equipment value needs to be included in the appraisal process and adjustments made to book value.