Buying or Selling a Business Understanding the Business Profitability

Buying or Selling a Business

Understanding the Business Profitability

Small Business Financials Recast Financials Seller desires to lessen tax distorts data If business exists 3 or more years, this suggests they are making money Many people live out of their companies expensing personal benefits to the business The top line is important, the bottom line is important, but what is in between tells the real story

Recast Financials

Seller desires to lessen tax distorts data

If business exists 3 or more years, this suggests they are making money

Many people live out of their companies expensing personal benefits to the business

The top line is important, the bottom line is important, but what is in between tells the real story

Recasting Financials The two financial documents that are adjusted are the Income Statement Balance Sheet

The two financial documents that are adjusted are the

Income Statement

Balance Sheet

What is Recasting Adjust The INCOME STATEMENT to determine SELLERS DISCRETIONARY EARNINGS ( SDE ) SDE is the amount of money the business generates to pay debt service and provide wages for the owner/operator An adjusted Income Statements gives the buyer an economic view of the business so a buyer can compare different businesses equally

Adjust The INCOME STATEMENT to determine SELLERS DISCRETIONARY EARNINGS ( SDE )

SDE is the amount of money the business generates to pay debt service and provide wages for the owner/operator

An adjusted Income Statements gives the buyer an economic view of the business so a buyer can compare different businesses equally

What is Recasting Adjust the BALANCE SHEET to Fair Market Value of the Assets to be transferred to a new owner Furniture, Fixtures & Equipment Inventory Accounts Receivables (not typical in small business sales) Banks will loan on assets and cash flow

Adjust the BALANCE SHEET to Fair Market Value of the Assets to be transferred to a new owner

Furniture, Fixtures & Equipment

Inventory

Accounts Receivables (not typical in small business sales)

Banks will loan on assets and cash flow

Recasting Financials Everyone has a different meaning of “Business Earnings” Possible Definitions: SDE - Seller’s Discretionary Earnings This is what we use for small businesses This can be equate to the owner’s lifestyle he is living out of the business EBITDA - Earnings Before Interest, Taxes, Depreciation, & Amortization This is typically used for larger businesses Private Equity Groups or Investors not managing the day-to-day operations will typically use this term The easiest way to think of EBITDA is that you calculate the SDE but then you subtract out a cost for a full-time manager’s salary and benefits since there will be an expense for someone running the show Net Income (or Net Profit) – Bottom line of tax return after all expenses Doesn’t really apply to small businesses since only the owner, accountant, and IRS are the only individuals to see this number. The goal in small business is to minimize so that less taxes are paid.

Everyone has a different meaning of “Business Earnings”

Possible Definitions:

SDE - Seller’s Discretionary Earnings

This is what we use for small businesses

This can be equate to the owner’s lifestyle he is living out of the business

EBITDA - Earnings Before Interest, Taxes, Depreciation, & Amortization

This is typically used for larger businesses

Private Equity Groups or Investors not managing the day-to-day operations will typically use this term

The easiest way to think of EBITDA is that you calculate the SDE but then you subtract out a cost for a full-time manager’s salary and benefits since there will be an expense for someone running the show

Net Income (or Net Profit) – Bottom line of tax return after all expenses

Doesn’t really apply to small businesses since only the owner, accountant, and IRS are the only individuals to see this number. The goal in small business is to minimize so that less taxes are paid.

Recasting Income Statements Recasting Example: Real Life Business We Sold 2004 Unadjusted Pre-Tax Profit = $43,721 2004 SDE = $277,076 An uneducated Buyer & Seller could view the profitability as $43,721 vs. $277,076 This is over a 600% difference!

Recasting Example:

Real Life Business We Sold

2004 Unadjusted Pre-Tax Profit = $43,721

2004 SDE =

$277,076

An uneducated Buyer & Seller could view the profitability as

$43,721 vs. $277,076

This is over a 600% difference!

Recasting Income Statements What items are typically adjusted? Depreciation Amortization Interest Officer Compensation Family salaries/benefits Officer Insurance Officer Auto Officer Fringe Benefits Rent Replacement Employees Sometimes positive, sometimes negative You must understand when you can adjust and when it must stay.

What items are typically adjusted?

Depreciation

Amortization

Interest

Officer Compensation

Family salaries/benefits

Officer Insurance

Officer Auto

Officer Fringe Benefits

Rent

Replacement Employees

Sometimes positive,

sometimes negative

You must understand when you can adjust and when it must stay.

Recasting Income Statements The bottom of the tax returns read: The owner’s lifestyle reflects the above numbers plus:

Recasting Income Statements Though the owner spent his “earnings” as shown on the previous slides, as a business buyer, you have the above amounts to spend to your discretion. This would include paying yourself a salary and servicing the debt required to purchase the business.

Recasting Income Statements General rule when recasting: If a new owner walked in today to replace the current owner, ask yourself, “What expenses are necessary to generate the current level of sales?”

General rule when recasting:

If a new owner walked in today to replace the current owner, ask yourself, “What expenses are necessary to generate the current level of sales?”

Recasting Income Statements Items to think about that we have seen in the past: Owner currently pays his employees 100% medical while his competitors don’t pay medical. Can you add this back? As an area developer of a franchise, the current owner pays 4.5% royalties versus the typical 6% royalty. Is an adjustment needed? The owner owns the real estate in a separate corporation and leases it to his business. The Fair Market Rent for the area is $2000 per month. To lower his business taxes, he charges the business $2500. Is an adjustment needed? For the example above, times now have been tough for the business so he decides to cut the rent to $1500 per month. Is an adjustment needed?

Items to think about that we have seen in the past:

Owner currently pays his employees 100% medical while his competitors don’t pay medical. Can you add this back?

As an area developer of a franchise, the current owner pays 4.5% royalties versus the typical 6% royalty. Is an adjustment needed?

The owner owns the real estate in a separate corporation and leases it to his business. The Fair Market Rent for the area is $2000 per month. To lower his business taxes, he charges the business $2500. Is an adjustment needed?

For the example above, times now have been tough for the business so he decides to cut the rent to $1500 per month. Is an adjustment needed?

Recasting Income Statements More questions to think about: The owner takes a salary of $80,000 and works full-time in the business. This is a fair market price for a person in this role in the company. The owner’s wife does all of the accounts receivable and accounts payable for the business. She works approximately 35 hours a week doing these functions. So they don’t have to pay social security taxes for both of them, she doesn’t take a salary since the $80,000 is sufficient for them to live on. Is an adjustment needed? The owner has a flower shop. He is expensing the delivery van through the business. Is an adjustment needed? The owner of the flower shop is expensing his BMW through the business. Is an adjustment needed?

More questions to think about:

The owner takes a salary of $80,000 and works full-time in the business. This is a fair market price for a person in this role in the company. The owner’s wife does all of the accounts receivable and accounts payable for the business. She works approximately 35 hours a week doing these functions. So they don’t have to pay social security taxes for both of them, she doesn’t take a salary since the $80,000 is sufficient for them to live on. Is an adjustment needed?

The owner has a flower shop. He is expensing the delivery van through the business. Is an adjustment needed?

The owner of the flower shop is expensing his BMW through the business. Is an adjustment needed?

Recasting Income Statements More questions to think about: The owner has a home-based travel business. The business spends $50 per month for internet service. Is an adjustment needed? The owner has a brother that works in the business who manages the paint department. A person of that skill level typically makes $35,000 per year. Because he is the owner’s brother, he is making $55,000 per year. Is an adjustment needed?

More questions to think about:

The owner has a home-based travel business. The business spends $50 per month for internet service. Is an adjustment needed?

The owner has a brother that works in the business who manages the paint department. A person of that skill level typically makes $35,000 per year. Because he is the owner’s brother, he is making $55,000 per year. Is an adjustment needed?

Recasting Income Statements Remember: You will not be able to accurately recast the financials of a business by just looking at the income statements or tax returns You have to ask questions to understand where add-backs (or subtractions) may exist

Remember:

You will not be able to accurately recast the financials of a business by just looking at the income statements or tax returns

You have to ask questions to understand where add-backs (or subtractions) may exist

Contact One of Our 3 Offices Confidential Business Sale, Inc. Independence Tower 5755 Granger Rd. Suite 360 Cleveland, Ohio 44131 Phone: (216) 739-0272 Fax: (216) 739-0279 [email_address] Confidential Business Sale, Inc. Laurel Office Park I 17177 N. Laurel Park Drive Suite 236 Livonia, Michigan 48152 Phone: (313) 221-9378 Fax: (313) 221-9379 [email_address] Confidential Business Sale, Inc. StanJim Building 5437 Mahoning Ave. Suite 2 Youngstown, Ohio 44515 Phone: (330) 423-0879 [email_address]

Confidential Business Sale, Inc.

Independence Tower

5755 Granger Rd.

Suite 360

Cleveland, Ohio 44131

Phone: (216) 739-0272

Fax: (216) 739-0279

[email_address]