Add-backs and Valuing a Business
(multi part series)
Recap from the last issue:
5 years of tax returns
Calculate weighted average of EBITDA
Multiply by 2 and 4
One of the reasons buyers and sellers may not agree on the value of a business is Add-Backs. These are typically expenses that you ran through the business, but weren’t necessary for your business to operate. For example, before I sold my tax practice, I built a new website and attended some training events related to my new focus on buying and selling businesses. I ran these through the "old" business. When determining my average profit, I let the buyer know, those expense didn’t count and should be added back. But the buyer doesn’t have to agree. What if the seller tried to add back failed marketing expenses? Would you expect a buyer to agree that was outside the realm of normal operations?
Another way the buyer and seller may disagree on the profit number is due to one time revenue events. If you’re a pizza shop in Indianapolis, and the Super Bowl is in Indy and somehow you become the official pizza shop of the event. That event brings in an additional $500,000 of profit that you never had before and never will again. That should not be included in your average profit calculation.
As much as we enjoy paying less in taxes, Sellers, you shouldn’t be running extra expenses through your business in the first place. This is an entire conversation by itself, but co-mingling your business and personal money can have dire consequences. For one, the IRS could classify you as a hobby. I know a hobby sounds like fun, but the IRS takes the fun out of everything. If they classify you as a hobby, it will greatly reduce your ability to take business tax deductions.
The second negative result that can come from co-mingling your business and personal money is in the case of a lawsuit. As soon as I said lawsuit, you probably thought, oh, you’re covered because you are an LLC or some other protective entity. But that’s my point. Co-mingling your monies can give an opposing attorney the opportunity to "pierce your corporate veil". That's a fancy way to say, if you don’t follow the rules on how to take care of your LLC, the attorney can get right through it and attack your personal assets.
Bonus Tip: Be consistent in how you record your business transactions. For example, if sometimes you record your website fees as Office Expenses and sometimes you record it as Computer Expenses: and sometimes you record your pizza carryout sales separately from your dine in sales, and sometimes you record them together, you’re going to end up with a jumbled up mess. It will be difficult for you to manage your business and difficult for your buyer to figure out what’s going on. And guess what? Doubt will imply risk and risk will lead to a lower valuation.
More on Valuing Your Business and Preparing for sale next time:-)
