Why Your Financial Statements May Distort the True Value of Your Business

Most business owners manage their businesses in a way that will minimize taxes. Most business owners minimize taxes at the corporate level by minimizing profits. Since many approaches to business valuation calculate value based on profitability, by minimizing profits you effectively minimize value.

There are many ways that business owners understate or reduce profits in a private company:

• Many business owners give themselves perks and benefits far above market value. They drain the corporation of cash through excess salaries, bonuses, and other benefits, thus reducing profit.
• Some owners purchase or lease assets that may not be essential to the business, such as automobiles, boats, airplanes, and so forth. Leasing payments that are expensed and depreciating these assets reduces profits.
• Making above market lease payments on equipment to a separate leasing company owned by the shareholders reduces the profitability of the company.
• If the company occupies real estate that is personally owned by the shareholders and then is leased to the company at above market rents, this also reduces profitability.
• Having family members that are not working at the business drawing paychecks or consulting fees reduces profitability as well.

Understating the value of the company’s inventories in order to overstate expenses effectively reduces profitability.

There are also certain business valuation techniques that take into account the assets and liabilities of the company to calculate value. Here, too, business owners can do things to distort the value of their company:

• The financial statements may undervalue equipment that is expensed rather than capitalized. There may be assets like intellectual property, contracts, trade secrets, and goodwill that may not be adequately provided for on the balance sheet.
• Equipment may be worth more than the value listed on the balance sheet because of accelerated depreciation.
• Some business owners may also own an outside leasing company that owns some or all of the equipment, thus understating the net worth of the business.
• Inventories on the balance sheet may be understated, which reduces their net worth.
• Some owners decrease the net worth of business by maintaining a high level of shareholder and other debt on the balance sheet.

Even though all of these are common ways to minimize the value of your business on paper, take caution. If you decide you want to increase your line of credit with the bank, or if you are thinking of selling your business, the fact that you have understated profitability and/or your balance sheet could create a big problem. What should you do about the fact that your financial statements may be distorting the value of your business? Please tune in next week for my article on how to resolve these kinds of problems, and check out my blog at ExitPlanPros for more information on how to plan your business exit.