Getting Your Financial House In Order - 5 Things You Must Do Now

About The Author - Randy Katz is a Cofounder of Synesis Advisors, a San Francisco based firm that works with clients in marketing, selling and purchasing privately held businesses that are traditionally underserved by investment banks.

In a business sale, the hardest barrier for the seller to overcome is often the ability to let go after 20/30/40 years in business. I’ve seen many more instances of Seller’s remorse than Buyer’s remorse in my handling of M&A. Yet even though business is humming and you’re ready to move on, the business may not be ready to be shown in the best light.

Just as you would stage a house for sale, a business should be staged. I’m not referring to cleaning the office when a potential buyer comes for a meeting (though you should do that too), but rather being able to show the true profitability of your operation. The more explanation it takes for a buyer to understand your financials and the higher amount of adjustments it takes to normalize your income, the higher probability that a buyer will discount your valuation. Think of it this way….if I don’t understand your financials or don’t believe an adjustment that you are making, I will perceive the endeavor as riskier. If I am willing to accept the risk, I will require a higher rate of return; hence offer a lower price.

Below are common issues that I consistently see when analyzing financials, though this list is certainly not comprehensive.

Multiple businesses units or locations with consolidated financials: 

I have seen a number of scenarios where a business owner has several franchises, multiple retail locations, multiple business divisions, or even disparate businesses all under one tax return and P&L.This is problematic when you are only selling one location, division, or franchise unit. Oftentimes, the revenue of each component is broken out, but the expenses are all lumped together. This makes it difficult to impossible to identify what percent of gross profit and cash flow is generated from each component of the business. If a buyer is unclear of the economics of what they are purchasing, it will be difficult to come up with an appropriate valuation and get through due diligence. Additionally, banks will have a difficult time underwriting loans, meaning sellers will likely receive less cash up front in their deal. In these instances, the minimum a seller should do is create separate P&Ls that are representative of the independent entities and divisions, noting how shared corporate overhead expenses are allocated. Depending on which issue above you’re solving, multiple business entities and tax returns should also be considered. 

Not taking end of year inventory

Businesses with a large number of SKUs or several hundred thousand dollars in inventory know the pain. It’s difficult to close the business for the day or assign the team with the mundane task of counting everything in the warehouse. The problem arises that you lose the ability to accurately calculate your Cost of Goods Sold (COGS). Let’s suppose that you finished the year with $200,000 more inventory than you started. It’s normal for a business owner to use their purchases as the COGS number, but in this instance, you have overstated your COGS by $200,000 and understated your income by the same amount. Additionally, there is a higher likelihood that your COGS as a percentage of sales will swing. These false swings will cause confusions regarding both your pricing power and the strength of your vendor relationships. It also makes it difficult for both the business owner and buyer to understand the amount of working capital needed to operate the business. For business owners who don’t want to spend the time, there are inventory counting services who can handle your inventory counts for you.

Reclassifying expense items

It’s not uncommon to change CPA’s, bookkeepers, or decide on one’s own that one line item may be better classified somewhere else. I’ve seen scenarios where variable cost field labor is considered a cost of goods sold one year and included in salaries and wages in future years. One’s CPA can be classified under professional services or accounting. You may break out worker’s comp insurance as a separate line item from your liability insurance in one return and consolidate them as a single insurance line item the following year. Any one reclassification can usually be easily explained and is not cause for concern. However, multiple changes year after year may ultimately require the hiring of a forensic accountant to unwind the confusion, which can be costly. Additionally, multiple changes will raise a red flag. Consider what a buyer will think…if you don’t pay attention to managing one of the most important aspects of your business, what else are you failing to pay attention to?

Personal expenses run through business

It’s a common saying with a wink and a nod… “I have certain benefits as a business owner in addition to my income.” While tax avoidance or deferral are legitimate methods to reduce ones tax liability and improve cash flow, tax evasion is another story. Personal expenses such as one’s Mercedes lease, travel and entertainment expenses, or child on the payroll that does not work in the business, may all seem like easy things to explain to a buyer. However, consider what a buyer will think when you begin the discussion about how your personal expenses will go away once they own the business…. “You’re okay being dishonest with the IRS when it benefits you financially. Now, you’re asking me to take your word for something when we’re entering into a negotiation that will benefit you financially.” In addition to the concern this brings to the buyer, banks that are often the source of capital for business transactions will usually not give you credit for these types of expenses. This could create a situation where the price is lowered or you are asked to carry a larger promissory note. For my normal disclaimer, please recognize that there are times you can have the best of both worlds. You may be able to justify financial adjustments that benefit your taxes in the short run and your sale in the long run. However, there are many instances that you may save 30 cents on the dollar in the near term, only to give up $3 for every dollar of incremental profit on the backend. Make sure you are working with your CPA and M&A advisor to understand which category your discretionary items fall into.

Lack of a Balance Sheet

Just because your P&L shows net income, it does not mean that you are making money. That’s right, your balance sheet tells a story too. For example, your business is on cash accounting, meaning that you recognize income when the cash is received. You have $500,000 in accounts receivable that should have been paid in December 2013. However, the client did not pay you until February 2014. During 2014, your business truly operated at a loss of $250,000, however when you add in $500,000 of cash received, it appears you made $250,000. Let’s consider a scenario that makes your financials look worse on the surface….you have a huge tax bill coming, so you pre-pay expenses for the following year. In that instance, the business will look less profitable than it should. These types of items can only be seen and understood when you keep an accurate balance sheet.

Remember that buyers are typically looking at 3 years of financial statements, as are the banks who are lending money. When you’re thinking about going to market, give yourself three years to get your financial house in order.

Understanding Your Balance Sheet's Impact on a Transaction

About The Author - Randy Katz is a Cofounder of Synesis Advisors, a San Francisco based firm that works with clients in marketing, selling and purchasing privately held businesses that are traditionally underserved by investment banks.

When evaluating companies, owners typically have a good sense of their profit and loss statement and want to make it a focal point of conversation. However, they don’t seem to grasp the importance of the company’s balance sheet.

The lack of understanding of one’s balance sheet and the poor quality of the information on balance sheets is cause for concern and can dramatically impact a transaction. Below, I explore several issues that can occur in a deal if the balance sheet is ignored by a business owner

Too Much Working Capital in Deal

When buyers make an offer on a business, it identifies the assets and liabilities that are being assumed in the transaction. An informed buyer will make an offer that includes enough working capital (current assets – current liabilities) that allows the business to continue operating without disruption. If the business has not historically managed its working capital correctly, a buyer may believe that the business needs more working capital than it does in reality. An example of this may be a business keeping more inventory than necessary in stock, or letting accounts receivable remain outstanding for longer than agreed upon terms. Should a buyer negotiate excess working capital in a transaction, money is being left on the table for the seller.

Net Income is Opinion. Cash Flow is Fact

The income that a business generates is not necessarily indicative of its performance. For example, a business using cash accounting may be increasing Y/Y, but if accounts receivable is increasing, revenue may be understated (on an accrual basis), or if accounts payable decreases, expenses may be overstated (on an accrual basis). The balance sheet is the best indicator of the cash generation ability of the business because it allows the business owner to measure the changes in business performance from one period to another.

Not Taking End of Year Inventory

Many balance sheets I look at have an inventory that is constant from one period to the next. Of course, it’s laborious to take inventory in a 20,000 foot warehouse or when a business has thousands of SKUs. However, the end of year inventory number is a key determinant in a company’s cost of goods sold. Should a buyer make an offer and find that inventory is overstated on a balance sheet, that implies that cost of goods sold is understated on a profit and loss statement, thus a business is making less money than the seller is portraying. It’s an awful experience for a seller to have a deal fall apart in diligence because the buyer made an offer and later renegotiates or reneges due to incorrect information being provided.

Rebate of Prepaid Expenses and Prepaid Revenue

The closing of every transaction has adjustments. Some bills are prepaid and the benefit is going to be gained by the buyer. This prepaid expense should be an asset on the balance sheet. Some clients pay cash before a project has started and the buyer will need to perform a service. This prepaid revenue should be a liability on the balance sheet. When negotiating a transaction, the buyer and seller need to identify the flow of prepaids to make sure they are negotiated, and ultimately need a mechanism to measure them upon the closing of a transaction so that each party is recognizing the revenue and expenses that belong to them.

Tax Consequences in a Resale

When a business is sold, the total purchase price is split up into categories, i.e., furniture, fixtures & equipment, goodwill, covenant not to compete, etc. This process is known as the allocation of purchase price. Each category is taxed differently, so optimizing the allocation can potentially result in significant tax savings to the seller. However, just because a tax rate in one category is higher than another does not mean that category is bad if the seller already has a tax basis in the category. A seller’s tax basis is changing continuously as assets are purchased, depreciated, and amortized, and the best way to keep track of the basis for each category is on the balance sheet. Remember, it’s not just important to maximize what you get, but what you keep.

In Stock Deal, the Buyer is Purchasing Balance Sheet

If you recall from prior articles, buyers are often structuring their transactions as asset deals, whereby they are acquiring all assets of the business, but not the corporate entity itself. Thus, they are not acquiring your balance sheet. However, for deals that are structured as stock transactions, the entity continues to operate as if nothing changed, such that the balance sheet is acquired. Buyers are weary of purchasing unknown liabilities and will use heavy legal representations to protect themselves if agreements are structured this way. The cleaner and more accurate the balance sheet, the higher probability a buyer will consider this deal structure and that a seller will keep from breaching legal representations.

There are numerous other issues that might exist, but this should underscore the importance of an often ignored element of your financials. For more information or to discuss your own situation, reach out to Synesis Advisors, your CPA or Lumiere for guidance.