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 financial statements (also known as 'add-backs').
What is Recasting Financial Statements?
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 financial statement 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 financial statements 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.
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
How to Perform Recasting
Recasting financial statements 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.
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.
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 when recasting financial statements, each document 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.