Business Value: Do Your Numbers Add Up?

Most small business owners don’t understand how to value their companies. For some, misunderstanding the way that buyers look at the value of your business can be very costly in the long run.

The fourth of our Rights and Obligations of a Business Owner says that you have the right to a company car, travel and other perquisites. However, these come out of your profits, and so out of your pocket, and both you and your spouse are obligated for all of your personal assets to guarantee everything.

Most business owners take advantage of tax laws by giving themselves at least a few benefits deductible as business expenses. Taking a company truck home at night or tacking a family holiday onto a business trip are widely accepted perks of ownership.

Usually, small businesses are organized under IRS rules that allow profits to be passed through to the owner without a separate level of taxation. Lenders recognize this when they rely on an owner’s personal financial statement to determine creditworthiness, and when they require a personal guarantee for a loan. This is their tacit admission that the actual monetary impact of owning the business is frequently more than what is reported on the profits line of its tax return.

Because personal assets underwrite the business, many owners feel that the business should bear as many of the owner’s personal expenses as it can. In lieu of allowances, family members are put on the payroll. Spouses and children receive company cars, with gasoline, insurance and repairs included.

Clothing becomes uniform expense.  I once knew an owner who spent tens of thousands of dollars annually for cowboy boots in exotic leathers, which were then deducted as work shoes.

When it is time to sell the business, valuations are based on a multiple of profits. How can an owner realize the full value of his or her company after years of keeping the profit numbers as low as possible?

If your business is small enough to be purchased by an individual, simple documentation of how you draw value out of the company is often enough. Business brokers will calculate your Seller’s Discretionary Earnings (SDE) as part of their workup for marketing the business. Any savvy buyer can understand that the same or similar benefits will be available to him once he takes ownership.

Larger organizations, however, may not be quite as understanding. If the business is substantial enough to require outside financing, the lender has more stringent rules regarding what can be considered “profit.” You might be able to explain a family member on the payroll, or an extra vehicle. Too many such items though, will make a lender wary of the accuracy of your books.

If your company is large enough to attract a major buyer, like a publicly traded company or a private equity group, they will usually base their valuation strictly on the results reported for tax purposes. Personal expenses cleverly hidden in the operating costs are disregarded in bigger acquisitions.

When you begin to think about selling your business, consider minimizing your personal expenses at least three years before starting the search for a buyer. Showing better profitability may cost you some added taxes in the near term, but getting 3, 4 or 5 times those profits in a sale more than compensates for the short-term sacrifice.