Recasting Financial Statements: How to Prevent Leaving Money on the Table

Selling

As a business owner, deciding to sell your business is one of the most important decisions you can make in your professional life. For years you perhaps assumed your children would carry on running the firm, but they have respectfully gone on to pursue their own dreams, their own careers, and taking over the family business does not interest them.

So the best option, as you have determined, is to find a buyer who can grow and expand the business while also providing you with the capital you need for your exit.

The question becomes: What happens next? You now need to start getting your business ready to take to market. To do so, you must collect a robust list of documentation. Each potential buyer is going to want to evaluate the financial well-being of your business prior to making an offer to buy.

Along with providing concrete evidence to the buyer, the goal of this process is to determine the true financial earning power of your business. In order to do this, you will need to perform ‘recasting’ (also know as ‘add-backs’).

What is Recasting?

Chances are that you have probably worked closely with your accountant over the years to strategically diminish your earnings for tax purposes. This is perfectly legal and can be done in a multitude of ways, but it also downplays the true value of your company. Such reported earnings could hurt the ultimate sale price of your business if they have not been reviewed and adjusted to incorporate add-backs before you list your company for sale.

Enter recasting… Recasting is the accepted accounting principle of going through each expense and determining exactly what items (fully or partially) could be considered either: a one-time expense that the future owner will not incur or;  an expense that is optional in nature and not a vital, business-related expense.

Why is it Done?

The ultimate goal of recasting is to construct a financial picture that reflects the true earning power of a company. It is important to understand that each of these ‘one time’ or ‘optional’ items could be considered earnings if not expensed in the same way by the new owner.

This step is critically important. It could lead to a gross undervaluation or overvaluation of a company if not done correctly. Hopefully the examples in the section below can help you navigate this important process and get you on your way towards a proper valuation for your company.

Related: "What is My Business Worth?"

Examples of Common Add-backs:

Every business is different and therefore, every business will have different add-backs. The key here is to highlight expenses where you can show that they were either a one-time occurrence or are not vital to the business. See below for examples of common add-backs:

1. Personal Expenses

Running personal expenses through the company is a common occurrence in small, privately-held companies. These personal expenses are considered add-backs because the buyer won’t continue to incur your personal expenses moving forward. Ex: automobile for personal use, non-business related travel, meals, entertainment, telephone, club membership(s), etc.

2. Legal Expenses & Professional Fees

One-time legal and professional fees that a business may incur (due to an event that will not reoccur) is considered an add-back. An example of this would be settling a legal dispute. The dispute itself is a “one off” event and it is not a regular expense, such as filing taxes.

3. Owner Compensation

Owners of closely-held, profitable businesses oftentimes give themselves oversized salaries and bonuses. The amount of the salary that is above market value for the position is considered an add-back (not the full amount). Ex: market value of a manager of a retail store is $50K and the owner pays himself $120K, you can add-back $70K.

4. Charitable Contributions

While donating to charity is a wonderful thing to do, it is not a necessary business function because the new owner doesn’t have to choose to continue to donate money on behalf of the company once they have purchased the business. The money that a company gives to charity could have been recognized as profit, so it is therefore another example of an add-back.
 
Again, you will notice that all of the standard add-back categories above can be considered either a one-time expense that the future owner will not incur or an expense that is optional in nature and not a vital, business-related expense. Recasting can be a tedious process but it is definitely worth doing in order to prevent leaving money on the table.

How to Perform Recasting

Recasting can take some time but the idea behind it is quite simple. Review each expense individually and determine whether it would be considered an add-back. From there, group common add-backs into topic-based categories (see example below).

Once you have completed something like the above table, the totals you come up with should then be added to your overall profit to show the total earning power of your company. Note: it is best to share the add-back list you make with the buyer in order to have full transparency.

Related: "Preparing a Business For Sale: What Buyers Want to See"

In Summary

Buyers pay close attention to a seller’s add-backs. There is a very good chance that a buyer may challenge you on the legitimacy of any given item. Therefore, it is important that each add-back can be validated and is justifiable. For each add-back, you should be able to answer the following questions: “What is it?” and “Why do you consider this to be an add-back?”

If a buyer finds add-backs that were wrongfully recorded, there is a very good chance that your credibility will be lost and, likely, the deal will fall through.