Small Business Taxes & ManagementTM--Copyright 2013, A/N Group, Inc.
How do you value a business? In the case of a publicly traded company the most common measure has been price-earnings ratio or P/E. It's the price of the stock divided by the company's earnings (usually based on the following year). The P/E varies by industry; for a utility it's lower than for a biotech company. The higher the P/E, the more expensive the stock. But it's also assumed that companies with higher P/E's have better growth prospects. But small companies are riskier and it's difficult arriving at a P/E ratio to be applied to the small company's earnings to compute a value.
Small businesses, particularly service businesses, are often valued on a multiple of sales instead of a multiple of earnings. For example, a landscaping service may be valued at 1X annual sales. One of the reasons for the difference is that small businesses are often subject to wide swings in earnings. Another is that earnings for a small business can be unreliable.
There are a number of other approaches to valuing a business including computing the net book value (assets less liabilities) discounted cash flow, etc. but most don't take into account the problems of most small businesses. They also don't account for what most small business owners are really looking for--a salary and a return on their investment in the business or purchase price. The Seller's Discretionary Cash Flow approach (also called Seller's Discretionary Earnings, Recast Earnings, Normalized Earnings, and Adjusted Cash Flow) is an attempt to address the valuation from a salary plus return on investment viewpoint.
In an ideal world, the approach would be simple. Take the net earnings the seller shows on his latest financial statements and add back his salary and depreciation, then subtract out what you want as a salary to arrive at what's left over to provide you with a return on your investment. Depreciation is added back because it's a noncash charge to earnings. So is amortization of goodwill, going concern value, etc. Interest is added back because it's anticipated it will be paid off on the purchase of the business. You want to add back to cash flow expenditures that aren't necessary for the business. For example, Fred's wife made him hire her brother when he ran out of unemployment. We'll discuss other adjustments below.
Example--Madison Inc., an S corporation is up for sale. The latest financials show a salary for the owner of $30,000, depreciation of $10,000 and net income of $80,000. The current owner has a number of rental properties which give him a good income, thus the low salary. You'll need $70,000 a year to support your family. Adding back depreciation and Fred's salary to the net income results in $120,000. Subtracting your $70,000 leaves you with $50,000 for a return on your investment. Would that be enough to give you an adequate return on the purchase price? More than likely if the asking price for the business is $250,000; not very likely if the asking price is $1.5 million.That's the theory in a nutshell. And, in some situations, that may be all the adjustments you need to do. But it's unlikely. In practice you'll have to make a number of other adjustments. The list below covers most of the factors to consider.
Starting point. You should be starting with the company's financial statements, not the tax returns. You'll need several years' worth. Three is the minimum. You might average the numbers from the three statements, toss out the outliers (a year with earnings far above or below the others), or use the results and adjust for significant differences. For example, on the statement you're using advertising expense is more than double the usual amount. Find out why and adjust accordingly.
You can use the tax returns, but you'll have to make adjustments to get to the starting point we'll use that's based on financial statements. For example, on a partnership or S corporation return Section 179 expensing of assets is shown separately and is passed through to the partners or shareholders. (On a Schedule C, that amount is included in the net income calculation.) That's also true for charitable contributions. Only half of meals and entertainment expenses are deductible on the tax return. Depreciation for autos and trucks may be limited.
Whether you use the financials or the tax returns, you should reconcile the two. Start with one, add or subtract the appropriate adjusting items to arrive at the other.
Pay particular attention to repairs and maintenance which could include capital expenditures and rent expense. Do a quick comparison of expenses from year-to-year to check for misclassified expenses. You should have more comfort in the returns and financials if they were prepared by a CPA.
Here are some of the most frequently encountered adjustments:
Owner's salary. This could go either way. Some owners take a almost all the earnings out of the company either as salary, distributions, dividends or draw. Some take very little. In S and C corporations owners take a salary. Beyond that they may take a distribution or dividend. In sole proprietorships, there's no salary for the owner, he takes a draw. LLCs and partnerships are closer to a sole proprietorship, but more complicated.
The first adjustment here is for the owner's salary. Add back the owner's salary and subtract out what you need for a salary. For many small businesses it's as simple as that.
But it could get more complicated. The seller may be a workaholic or have special skills you don't. You may have to hire a person to replace some of his skills. That could go the other way. The current engineer is looking to retire. Because of your skills you don't need to replace him, you just need a sharp secretary to handle some management duties you won't have time for. And, of course, you'll be able to lay off the owner's brother-in-law. (Or you may have to hire yours!) In some cases, a spouse will have the skills and work for free--at least for a while.
Things will be more complicated if there are multiple owners to the business, but the approach is the same. Don't forget to factor in pension costs.
Payroll changes often produce the biggest adjustments, particularly in a small business. Don't forget to factor in the cost of employment taxes, employee benefits and related employee costs. Benefits include not only items like health insurance (most likely the biggest one), but also pensions. See below for perks.
Depreciation. Depreciation (and amortization) is added back because it's a noncash charge. Depreciation is required for tax and accounting purposes to match expenditures for equipment to the period that receives the benefit. But as an owner, you're just interested in the cash that gets to your pocket.
But there's a flip side here. In many businesses assets have to be replaced on a regular basis. That requires a cash expenditure in a later year. You should subtract that from the earnings. How much and when is the question.
What's the status of the company's assets? There are three possibilities. One, the seller has kept up with replacements and repairs. Replacing computers, tools, etc. as required each year. You should be fine keeping to the same schedule. Two, the seller hasn't bothered to replace items, knowing for several years he was going to sell out. You'll have to replace office carpeting, all the computers, update the network, replace old and nonworking tools, obsolete equipment, and worn-out vehicles. (In this case you won't adjust the annual cash flow, but the purchase price in computing your return.) Three, the seller just brought all new equipment, tools and computers. Or, capital requirements of the business are minimal, e.g., as in a consulting practice. Either way your purchases in the next few years will be minimal.
Some businesses have minimal assets, some are heavily dependent. Some assets have long lives, but significant annual maintenance costs. If you're unfamiliar with the business, get good advice on how to make the adjustments.
Some capital expenditures probably shouldn't be subtracted from earnings. For example, the purchase of new equipment to expand the business.
Interest. Interest expense has to be added back because it's not counted as an expenditure. It's related to funds that have been expended (e.g., interest on a loan to buy equipment), so it's got to be added back.
Extraordinary items. There are items that might have affected net income, but that are not normal in the business. For example, expenses related to hurricane damage to a business in upstate New York. Hurricanes are rare occurrences in the area. On the other hand, while you might want to adjust (up or down) similar expenses for a Florida business, hurricanes there are far from rare. Other examples could be lawsuits, costs associated with the discontinuation of a product line--or the acquisition of a new line.
Perks. This is the big one for most small businesses. Personal use of company cars, payment of personal expenses by the business, relatives on the payroll, personal meals charged to the business, excessive entertainment, etc. Sometimes identifying which perks can be eliminated is easy, sometimes it requires much more effort. Since digging for these expenses can be time consuming, you should get an idea of the magnitude before jumping in. For example, personal use of vehicles by the owner of a lawn service could be difficult to find. On the other hand, charges for major league baseball games, dinners at expensive restaurants, etc. for the same business that has only small residential customers should generate suspicion. You may be able to get an idea of the magnitude without a detailed analysis.
How you deal with them depends on the situation. If the business should have little or no T&E, you might just inquire of the current owner and add the bulk of it back. If the number is significant and a high percentage could be legitimate, you'll have to do an analysis. That may mean going through the company's ledger or credit card statements. Your CPA should be able to help with the best approach. If he or she is familiar with the industry, they should have an idea of the usual costs.
Here are the items where adjustments may be required:
Here's a comprehensive example. Fred is interested in buying Madison Electric, Inc., an electrical contractor that does commercial installation and maintenance and highway and parking lot lighting. Many of the items in the pro forma statement are self-explanatory. The owner's wife is also a part-time bookkeeper, but collects no salary. Fred needs to replace her and anticipates spending $11,000 a year on an outside service. The assets are in good condition, but Fred will have to buy a new truck approximately every two years and other equipment annually. The $60,000 represents half the cost of a truck plus the annual expenditure for replacement equipment. The seller owns the property where the business is located. He hasn't raised the rent in 10 years. Fred has been informed the rent will increase by $42,000 if he decides to stay in that location. That would make it comparable to other rents in the area. Fred found the owner expensed heating oil for his home, gym membership, and various equipment items (riding mower, laptop, etc.) that were not used in the business on this year's financials. The total amounted to $36,000. Salaries include associated payroll taxes. The numbers for 2012 are:
There are a number of adjustments--both positive and negative. After Fred takes out a salary for himself, the net cash from the business should be about $341,000 (the actual number is $340,700). That's what should be left as a return on Fred's investment in the business.Net income from financials $235,000 Add: Owner's salary 110,000 Add: Brother-in-law's salary 40,000 Less: Buyer's salary ( 75,000) Less: Part-time bookkeeper to replace owner's wife ( 11,000) Add: Depreciation 85,000 Less: Projected annual equipment investments ( 60,000) Less: Increased rent ( 42,000) Add: Personal purchases expensed on business 36,000 Add: Golf club membership not business related 17,000 Add: Trips not for business purposes 5,700 Net return $340,700
This exercise will also force you to take a look at the numbers and determine if you can pay yourself a salary and service any acquisition debt from the cash flow.
There's more to valuing a business than arriving at the seller's discretionary cash flow and putting some sort of multiple on it. There are other methods to value the business. But if you're buying the business, it helps to know that you'll be getting a certain amount of cash in return for your investment. Whether that amount is sufficient depends on your desires and the business risk. Some individuals would be happy with paying $2.0 million to get an annual payout of $341,000. Some would not. You might still buy a business with low earnings if you believe you can boost sales and earnings.
And we haven't discussed risk. There are many more risk factors in a small business than a large one. One key employee getting sick--or winning the lottery and quitting--could severely affect the business. Business risk varies by industry, and not infrequently the type of work or product line. If a high percentage of Madison's revenue came from government jobs that had to go to bid each year, the business might be riskier and Fred might want a much higher return.
There are other factors including the valuation of the hard assets (e.g., equipment) and growth rates and potential, residual values, etc. But this is definitely your first step. If the business can't (now or in the future) pay your a decent salary and provide a return on your investment, it doesn't matter what a formal appraisal will show.
Seller's Point of View
Seller's may also want to go through this exercise before considering a sale of the property and setting a price. No matter how much the assets are worth, you won't get many interested takers if there's no cash remaining after the buyer takes a $50,000 salary. You may be able to sell out to a much larger company that just wants your book of business. Or you might want to consider holding off for a couple of years to put the business in better shape.
Copyright 2013 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 08/09/13