Cash flow is the common denominator in determining the value and ultimate selling price of your business
…Yet owners are loathe to put the actual number on the page for many reasons, most of all taxes. Just the thought of compensating a non-owner, shareholder (Uncle Sam) who has no investment in the business drives some owners to be overly creative in reducing the business’ taxable income.
When preparing to sell your business, your creativity may put you at odds with the goal of maximum value for your life’s work if you don’t identify your tax minimization strategies.
Buyers look for many things in buying a business, yet the most important is:
Does the business create enough historical cash flow to recover buyer investment in a reasonable period of time?
Right out of the gate, the seller is in the position of defending his asking price. If the seller’s stated cash flow does not support the asking price, the seller must define (explain) the gap between stated cash flow and actual. If the differences are not identifiable and documented, the whole process melts into a pool of unrealistic expectations, lack of trust, and frustration. Not a good way to sell your business for maximum value.
To begin with,
don’t feel like the Lone Ranger when it comes to tax minimization strategies. The game was created when the Act of 1862 established the office of Commissioner of Internal Revenue. Since that point citizens have been challenging the IRS with very creative ways of minimizing business income.
Every buyer expects the seller to have used whatever legal tools are at their disposal to minimize their tax liability. The seller just needs to identify and document the expense. Once identified, the amount is “added back” to the stated cash flow of the business, and cash flow is now “normalized.” The goal is to define the “adjusted normalized cash flow of the business“- the amount of cash, through normal business operations, the business generates that is at the discretion of the business owner.
With the cash flow normalized, the buyer will look at the historical predictability of the cash flow to repay the amount needed to buy the business in a reasonable period of time, typically three to five years. (For those of you interested in the term “multiples” relating to business sale, this is the what is meant).
Determining historical cash flow may present a problem if the seller just began planning his exit in the year he wants to sell the business.
Remember, the buyer is looking for three to five years of predictable cash flow to repay the purchase price of the business. That means that the seller must “normalize” the business cash flow for those three to five years. Reconstructing expenditures is time consuming, frustrating, and can be expensive.
Expenses like interest and depreciation are easy, but what about those items that – due to tax minimization strategies – were expenses during the year that could have been capitalized? Compound the difficulty by reconstructing those decisions over three to five years! Travel and entertainment accounts are another expenditure that would be hard to reconstruct. The list can be lengthy. The price to be paid of missing expenses that “add back” to earnings is measured in the “multiple.” So $50,000 of legitimate normalized cash flow missed can cost the seller $150,000 to $250,000 on selling price.
How do you avoid the potential loss of value of your business?
Plan on when you want to exit your business using three to five year periods and identify and document the tax minimization strategies used in each period. By creating the record, you are building the defense of what your business is worth to justify your asking price at some future date, and when it’s time to sell and move onto your Life Beyond Business,™ you’ll be ready!