Those of you who know me may be surprised by the subject of this month’s newsletter. It’s not a point I make often, and I certainly don’t want my own taxes to go up, so it may come as a surprise that I am about to argue that there comes a time when paying more taxes is to your advantage.
If you’re still reading, let me provide some context. The vast majority of your time spent owning a company should be focused on growing both your business and your personal income, and the two are usually directly related. Therefore, finding ways to reduce your “on paper” business income by treating personal expenses as business expenses lowers your tax bill and helps accomplish this objective. To this end, most small business owners write off everything they possibly can; however, the final years before selling the business call for a change in strategy, because declaring as much income as possible can increase the price you receive in a sale. Let me explain.
Profitability and cash flow are the key drivers of a company’s value. Even buyers who utilize revenue multiples incorporate cash flow into their valuations. Simply put, more cash flow means a higher price.
When we prepare a company for sale we will make certain adjustments to a seller’s financial statements in order to identify personal and one-time expenses that are not directly related to the operations of the business in order to present a clearer view of the buyer’s cash flow after the sale. This helps the buyer understand how the seller was running expenses through the business and that the business generates more cash than is shown on the tax return. Whether the cash appears on the bottom line or is buried in expense line items, we will find it and add it to the net income to calculate adjusted cash flow.
This adjusted cash flow will become the basis for our valuation, but – and this is a huge but – it might not be the basis for valuations done by a buyer or lending institution. Certain add backs are obvious: interest, tax, depreciation, amortization, owner’s wages, and the lease of a company car. Some are a little gray but can be acceptable, like travel and cell phones; typically, if these are their own line item they can be relatively justifiable. Other expenses that are buried within line items, however, can be much more difficult to justify. And when they are tough to justify and/or appear hidden, buyers are less likely to accept them. If you are willing to mislead the IRS, why should a buyer believe that you are being honest with them?
When a buyer requires financing in order to complete the deal, the bank’s valuation is all that matters. Banks, especially the SBA lenders most commonly used in small company transactions, will not accept many of these add backs; they usually accept the obvious add backs (as specified in the previous paragraph), but may discount the rest 100%. So, by eliminating the personal expenses you increase net income and make your business more attractive to buyers and lenders alike.
Many buyers value companies based on a multiple of cash flow, so achieving agreement on the adjusted cash flow number is critical to convincing a buyer to accept your asking price. The one thing no buyer can ever dispute is net income, so by expanding your net income you eliminate many of these concerns.
Consider $10,000 in personal expenses that are buried in a variety of line items. By running this $10,000 through the business you probably save $3,000-4,000 in taxes; however, if the buyer does not treat these expenses as add backs it could cost you $30,000 to $40,000 in purchase price. Think about it: pay an extra $3,000-4,000 now and get it back 10-fold in the sale. The extra taxes you pay in the final year or two before a sale could literally be the best investment you ever make!