Increase Business Valuation by Paying Income Taxes
Maximize Business Selling Price – Render unto Caesar…
I recently had a client with a very successful business who wanted to sell his company. It was a distribution business with a track-record of earning an excellent gross margin, with a good deal left over after operating expenses. But it was time for him to exit the business, and enjoy the next stage of his life. We agreed on a selling price, and I started marketing the company.
The asking price was fair, and I had a number of interested buyers in a reasonable period of time. In fact, despite some serious challenges in this particular business, I had two good offers from qualified buyers. However, the seller decided to postpone the sale until he finished the year. He was expecting a much better year, and planned to ask for a higher price.
What Happened: I received the year-end financials four months later. Sales were up 25%! Great! But why was the cash flow less than the previous year? The Cost of Goods Sold [CoGS] had almost doubled, which ate up his expected profits.
In discussing this situation with my client, I explained that his decline in cash flow, due to the increase in CoGS, resulted in a lower valuation for his company. After a long talk, it became apparent to me that my client had artificially increased his CoGS in order to lower his taxable income – and lower his tax liability.
No amount of reasoning could convince my client that, while attempting to save 30-40% of his cash flow by “deceptively” (I used a euphemism for that word) lowering his income taxes, he was reducing the market value of his business by 300-400% of that tax savings. Actually, I told him that buyers and bankers would look at the comparative financials, and think that he had fudged the books to lower his taxes. I didn’t want to appear to be calling him out myself.
Hi-Cash Flow = Hi-Business Valuation: This inability, or unwillingness, of some business owners to understand how buyers value a business has been a never-ending source of frustration to me and my fellow M&A professionals. Many business owners believe that higher revenue, or greater accumulation of inventory, or how many years they’ve worked on their business translates into a higher business valuation. And, many sellers also feel that everyone cheats on their taxes, and that buyers will understand how much money they can make if they purchase the seller’s business.
However, these sellers disregard the impacts of unreported income on business valuation: (1) most business owners do NOT cheat on their taxes – and buyers are hesitant to believe sellers who do; (2) bankers disregard unreported income when determining lending amounts for business acquisition financing; (3) the most important factor in determining business valuation is the amount of cash generated by the business, and (4) under-reported income [including artificially increases costs] depresses the value of a business by about ten (10) times any savings in taxes.
Takeaway: The most important factor in determining business valuation is the cash flow for the previous 12 months. Before and after making the decision to sell, business owners should operate their businesses as if they were going to keep it for at least five more years – maintaining their equipment, continuing their normal marketing expenditures, retaining their people with market-based wages…and reporting their real income for income tax purposes!
If you’re interested in learning more about business valuation, check out our Valuation Services.
The Summit Acquisitions Group — Business Brokers and M&A Advisors — specializes in the sale, appraisal, and financing of privately owned companies ranging in valuation from $750,000 to $25,000,000. Contact their offices in Atlanta, GA or Charlotte, NC for a free consultation.