Adjusting Financial Statements for Privately-Held
Businesses.
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Many business owners expense personal expenses through
the business in an effort to pay less taxes. It is a
common practice that buyers are aware of and will make
adjustments to determine the true profitability of a
company. Buyers are interested in the economic benefits
that a business generates, which often include owner
operator-type expenses. Experienced buyers expect that
privately held companies are operated in a manner that
minimizes taxes. The focus of adjusted financial statements
is to present the results of the business operations
as a buyer might inherit, exclusive of the perquisites
of an owner-operator. The key is to know which normalizing
adjustments are acceptable and which are not.
Common adjustments
An easy way of thinking about which expenses can be
adjusted is to ask yourself what expenses would the
company no longer incur when the business changes hands
and are not necessary for the ongoing operations of
the company. Common line items in the income statement
where adjustments are made include:
- Personal travel
- Auto expense
- Life/health/disability
insurance
- Club dues/fees
- Excess shareholder salaries
- Shareholder bonuses
- Non-active family members
on the payroll
There are many more, but these are the most common.
Excess expenses are fairly easy to assess and adjust
for, but salary is another issue. Typically, a buyer
will see what the replacement cost is of hiring a person
to fill your role. For example, you give yourself a
salary of $500,000/yr. and the cost to hire a President
for a company your size is $200,000. Thus you would
eliminate (i.e. “add back”) $300,000 of
expenses. In a scenario where the shareholder is inactive
and the buyer would not incur a replacement cost, the
whole salary would be added back.
Salary adjustments can also work the other way. If you
own a company as a pass through entity (Sole proprietorship,
partnership, LLC, or S-Corp) and you give yourself either
no salary or less than industry average salary, you
will have to make a negative adjustment to the earnings.
Real Estate
In many instances the shareholder(s) also own the real
estate individually and lease it to the company. If
the business is paying a higher than market rate, the
excess rent would be added back to earnings. Conversely,
if the company pays less than market rate, the difference
would be subtracted from earnings.
One time non-recurring expense
Buyers will often also take into account non-recurring
expenses. For example if you had a large write off in
inventory or extraordinarily bad debt or a settled lawsuit,
these expenses can be deemed as a one-time anomaly that
will not occur in the future. These too can be added
back to earnings.
Documentation
In order for you to ensure that the buyer accepts your
“add backs,” you should document your discretionary
expenses. Many times these expenses are hidden in financial
statements prepared by an accountant. You should always
keep two sets of financials, an internal set and an
external set. The internal financials should itemize
shareholders discretionary expenses. The better you
document this, the higher likelihood that a potential
buyer will accept these adjustments.
A word of caution
Synergies that the buyer brings to the table are not
adjustments. For example, if they can reduce head count
for redundant accounting functions or sales force, these
cost savings are not adjustments that you would make.
The best way to think about it is that if you left the
company, how much of the discretionary expenses would
be added back to the company, and that is the number
that can be adjusted. Although synergies are not a financial
statement adjustment, they should be highlighted and
presented to help negotiate a higher purchase price.
As you can see, there are ways to present a business’
true profitability. Normalizing your financial statements
is a widely accepted practice. The key is to keep accurate
records, understand the true earnings of the business
and communicate clearly with a potential buyer.
