Some business brokers (and sellers) get very aggressive when it comes to adjusting financials statements. Besides automatic addbacks for taxes, depreciation and interest (these are added back by definition), you can also make adjustments for one-time expenses and discretionary expenses. But it isn’t a cut and dried formula and it takes a little common sense to apply the rules.
The very basic premise of these adjustments is that you are trying to estimate what a buyer will experience in the future as the new owner. It is that simple.
I was reviewing the financial statement on behalf of a client who was looking to buy a high-end closet and garage organizing business. Almost every account had an adjustment and I was having a hard time taking it all in. Why, for example, is there an adjustment of $6,500 for tools and equipment? I was told it was a one time expense, and the tools purchased last a very long time. OK, why the adjustment the year prior? Different tools I was told. Wasn’t it possible that each year there are tools to purchase? In other words, the broker was saying that the new owner would not have to purchase any tools or equipment to sustain the business. Probably not the case.
How about travel, in which almost everything was added back? Well, I was told, much of that was personal, and the remainder was to go to an industry convention that they go to each year. In a buyer / seller meeting the seller told the buyer the convention was great and they learned a great deal about running the business. Doesn’t sound like not going to the convention is an option, does it? In other words, this is not a discretionary expense.
The financials were also packed with personal expenses, like airplane expenses, phone, auto, undisclosed credit card, travel, etc. You learn quickly in this business, quite possibly the first day, that adjustments for personal expenses that were run through the company for tax reasons are quite common. You often hear that “everyone does it”, and practically everyone indeed does do it. But there is a limit. The IRS has a limit, the SBA lenders have a different limit, and the individual buyers also have a limit. At some point, everyone gets a little uncomfortable (well, except maybe the sellers) and you start to wonder, “gee, if the seller goes to such great lengths to hide that much money from the IRS, might they also try to take a little extra money from the buyer”?
That was exactly what I was thinking, and my guard was up. Could I see the details of the credit card purchases that were personal? No – that was the owner’s wife’s personal credit card and that should be enough evidence that it was purely personal (but paid for by the company).
If you’ve read my earlier posts, you know that a company’s value is directly affected by earnings. More specifically, future earnings. It became apparent to me that a new owner would not enjoy the profits that the seller and broker had calculated, and thus the business wasn’t worth the asking price. We rejected some of the addbacks and came up with an offer based on the same multiple of earnings that the asking price used. The seller became quite angry because we had challenged the addbacks. So angry, in fact, that we never heard from him again.
Don’t get me wrong, when we represent a seller we try hard to root out any and all adjustments we can use, but we also try to apply some good old common sense on which adjustments should be included.
I did hear that the seller in the example did not sell the business last year, he is now on his third business broker, and it is now on the market again for a much lower price. Quite a bit lower than our offer. Not that I’m keeping track or anything.