If You Want to Sell Your Business Get Your Head out of the Financial Sand

If you came to this chapter expecting to find detailed charts and graphs with recommendations about the format of your financial reports or improving your profit and loss ratios, you’ll be disappointed. There are any number of great accounting books available to answer those questions. My goal here is to help you improve your numbers, not just improve the way they are reported. Most owners can sense how their business is doing, even before they have the detail from the financial reports.

Financial reporting is one of the key areas where buyers will look at the maturity of your business. For very small businesses, the owners often start off keeping the checkbook themselves and only visiting an accountant at tax time. Larger small businesses may grow to the point where they have a finance department and an in-house CPA who functions as their CFO. The financial maturity of the business doesn’t always keep up with its growth, which will become very apparent during due diligence. You will need to look at your business honestly as part of your preparation for a buyer’s financial assessment. I generally recommend that my clients try to kick it up a level by implementing a financial infrastructure that will support their business at the next level. The rational for this is simple—you should be planning for your next level of growth and positioning your business to demonstrate that to a buyer.

In my consulting business, I often work with business owners who have an uncanny ability to understand the complex financial reports of their business, asking detailed questions in their monthly reviews that drive their bookkeepers, accountants, and CFOs to the edge.

“How did he know to ask that?”

I also work with owners who have risen through the ranks in their industry and are acknowledged subject matter experts at what they do, but who are absolutely bored to tears when they are required to attend financial reviews or review financial reports. They barely understand what their financial reports are telling them without an interpreter to explain what the reports mean. I’ve also seen both types succeed, sometimes despite themselves, and I’ve seen both types fail, despite their best efforts.

“I’ll figure out how to make the technology work, you tell me if I’m making money.”

My rule is simple. If you expect to sell your business, then don’t treat it like it’s a hobby.

If you operate a business with transferrable value, and you expect someone to be willing to buy it, then you will have to demonstrate that value to them. You need to regularly create and review your financial reports, meaning you should already have the financial data ready to present to a buyer. Financial data must be accurate and easy to interpret. What you present to a buyer can reveal a lot about your management style and ability. Relax and do the work necessary to have your financials prepared so they work for you and not against you; if you’re not prepared to explain them, get someone who is able to help you.

Even if that data isn’t in an optimal format to support the sale at this time, the data should already exist in some form. You need to gather the data and prepare it to be reviewed by your buyer. Whether you are intimately familiar with your business financials or are simply sitting through the reviews trying to keep up, your financial reports will be core to getting your deal done.

Small business owners have a wide range of financial skills and use different management and reporting methods. Some owners are absolutely by the book financial managers who insist on a formalized financial management system, including a monthly income statement, balance sheet, and cash flow report prepared and reviewed regularly with their management team. These reports are tools used by management for their day-to-day operations decisions to help management identify trends and make sound financial predictions. In larger, more mature organizations, financial decisions can be delegated in this manner. Other methods, unfortunately common in many smaller businesses, are much less formal and are far less rigorous. There are owners who look almost exclusively at cash flow and others who manage by the shoe box method (they throw all their receipts in a shoebox and, if there is money in the bank after emptying the box and paying the payroll and bills, they are happy).

I am not endorsing either style. If your goal is to sell your business and get the maximum return for it, then it’s time to apply some rigor in the generation of your financial reports. This may mean changing your financial operations going forward and (yikes!) re-creating and documenting some history. You will need to be prepared with at least three years of past monthly financial reports to satisfy most serious buyers.

Unfortunately, preparing financial reports to be given to someone else to review is a task some small business owners fear enough to make them hesitate even putting their business up for sale. Some larger small businesses have similar problems producing past reports; just different rationale for not having the data.

“We’ve never worried about preparing those reports and I wouldn’t know where to begin, so maybe our business just can’t be sold.”

“Our financial system isn’t capable of going back that far.”

These are all owners who fear discovery because they know it may disclose that the past performance of their business wasn’t stellar (or their lack of understanding about how to read those reports will be exposed), or it may show their lack of financial maturity as the business grew. While they know they can’t avoid it, they want to delay any financial discussions with a buyer as long as possible. Their hesitancy to discuss their numbers with a buyer could result in even more questions than answers. Get busy and start trying to recreate those reports for the last three years and put a system in place to produce reports every month going forward.

“I requested a copy of their financials for the last three years but they’re hesitating to provide them. What are they trying to hide?”

If you don’t regularly review your financials and your financial data isn’t readily available, then you have work to do. Financial archeology requires a lot of digging that will absolutely be required if you intend to sell your business. Be thorough, be accurate, and be as honest as possible. If you need to make assumptions to reconstruct your financials, be sure to document those assumptions. In these situations, worse case assumptions are easier to defend than best case assumptions. Give yourself credit by “taking the high road” when you make assumptions.

“This is a worst-case assumption.”

“I no longer have our past utility bills, but I know the rates have gone up so I’m estimating the past expense using our current bills and assuming them as a worst case.”

Unfortunately, what many small businesses use as financials are actually cash flow statements and don’t meet the standard of a true balance sheet or income statement. For that reason, the bookkeeper used by many small businesses to support their day-to-day operations is generally not the person they should use to prepare the detailed financial reports needed to support a buyer’s financial due diligence. Your bookkeeper should be available to answer questions, provide the raw financial data, and support the CPA you will need to hire to correctly prepare the reports. Look for a CPA that has business transaction experience that matches deals the size of yours.

If you can’t provide even the raw financial data, your business may not be salable at this time. Waiting to sell until you are able to hire someone to implement a financial system that will be able to produce verifiable financials is a smarter business decision. Don’t wait to find a CPA. The sooner you get one in place the sooner you will know how large of a problem you might have.

Putting your Financial House in Order

Even if you are one of those who treat their business like a business—meaning you have all the financial data you will need (or you have collected it since reading the last paragraph)—your financial positioning will still require formatting and recasting (making acceptable adjustments) to your financial reports, optimally for at least the last three years of operation, so that they can be presented to a buyer.

Financial reports need to be self-explanatory and easy to read to determine the past performance of the business. They should answer questions without the need for further explanation. You don’t want your financials to become the source of additional questions. Reformatting and recasting of your financials should never be treated as an opportunity (or suggestion) to create an alternate set of books. This means you will need to use the past performance data as it exists—good, bad, or ugly—in the reports.

Reformatting of your financial reports is done to put your current (and correct) financial information into an acceptable, standardized format that can be reviewed by the buyer’s financial team—your CPA and theirs may need to be able to “mind meld”5 to come to a common understanding about the financial data you provide.

Plan to provide a clean, freshly bound set of financial reports that a potential buyer can use to support their financial due diligence assessment. Ideally, your CFO or accountant is accustomed to preparing these reports as part of your normal operations and can produce them at any point for your own use. If you review your financials each month, supporting a buyer’s financial due diligence shouldn’t be a problem. Financial due diligence allows the buyer to analyze and validate your financial data to gain as true an understanding of the fiscal performance of your business as possible, so you must be prepared for the assessment. You cannot put this task off until the start of due diligence while hoping the buyer won’t request the information. They will, so get busy. You can’t afford to start stuttering when the buyer begins asking financial questions because it may appear you are trying to hide something.

“Why doesn’t she know what it costs to deliver that product, and why is she hesitating to give us a straight answer to our questions?”

If you don’t know the answer to a financial question, try not to leave it floating. Send someone to get an answer as soon as possible; don’t appear to avoid the question.

“I don’t have an immediate answer, but I will have it for you by tomorrow morning.”

As a continuing financial operating practice your accountant or CFO should archive copies of each monthly balance sheet and income statement. If this isn’t already one of your established business practices, this is a good time to start (and yes, prepare to enter the data for the last three years, month by month, if you don’t have them). These reports can be produced using a spreadsheet, but basic accounting software, which is relatively inexpensive these days, really makes life easier. The method used to produce the report isn’t as important as the accuracy of the reports you produce.

Small businesses that do their fiscal management strictly by watching their cash flow frequently run into financial due diligence problems. Avoid those problems by preparing now. Unfortunately, the conclusion a potential buyer may reach is that you are trying to hide something (or worse, that you are not smart enough to read a standard report; either of these conclusions could kill your deal!). The quality of your financial reports and the accuracy of the data you provide will tell buyers a lot about the way your business has been operated (and may drive how they perceive your management skills) and could impact the value they place on your business. Keep this in mind if you are considering working for them following an acquisition. If you, or someone on your transition team, doesn’t have an accounting background, spend a little money and hire a professional to prepare your financials.

Financial reports should not be prepared solely to get you through the financial due diligence assessment. If you are operating a business and not a hobby, there is no excuse for not knowing how to read a profit and loss (P&L) report or a balance sheet, so stop making excuses. I suggest reading How to Read a Financial Report by John A. Tracy.6 There are usually inexpensive basic courses offered at most community colleges. By providing standard financial reports in a format familiar to a buyer, you are protecting your own credibility and removing the need to explain your accounting system or to explain its uniqueness. If you are not able to present these reports, then any accountant can help you and will be worth what you pay them. You must be prepared with the following reports:

The Dichotomy Dilemma

The natural tendency in any business is to try to minimize the taxable income of the business by minimizing the earnings they will be required to pay taxes on. There are some owners however who attempt to avoid taxes by not declaring all their income. This is of course illegal, but what those who do this don’t recognize, at least not at first, is that they are cheating themselves along with the government. Many small business owners learn this lesson early in the operation of their business. One day the business will eventually grow to the point where they turn to a bank for a business loan. The conversation with the bank will be short and go like this:

“Can we have a copy of your tax returns for the past three years?”

And then the owner is surprised when they hear,

“Gee, these returns don’t justify all the income you listed. Loan denied.”

This is when it dawns on them that they have been playing a fool’s game.

The dichotomy occurs because, when they eventually reach the point where they want to sell their business, they want to do just the opposite. Now they want to justify maximizing all the income they possibly can and lowering the expenses. When they’re selling their business, their goal is to try to maximize as much income as possible to get the greatest possible valuation for their business. A natural dichotomy exists between what owners declare on their taxes and what they are trying to state as actual income to the buyer. Note, I am not referring to valid, ethical recasting of their financials, which I will get to later in this chapter, but to an ethical issue that many small business owners face. This is the point where some small business owners end up with brown stuff on their faces and look like they have been “throwing stones at the outhouse.”

So, you are a risk taker and your business has been doing well. You explain to your friends (with a wink and a nod) that it is a cash business and you bring in four times what you claim for tax purposes. They nod and think, “man, he sure is clever.” But you are about to find out that clever person just outsmarted himself. They may have trapped themselves into devaluing their business. Let’s say, for a simplified example, your cash business brought in $1,000,000 a year for the past three years. You, being a shady owner, only declared $250,000 of that. At a rate of 30% × (1,000,000 − 250,000), you saved $225,000 in taxes. Quite a savings, right! Let’s continue the example. Suppose when businesses like yours are sold they are getting a multiple of roughly four times revenue. During due diligence your buyer asks for your tax returns for the last three years. 4 × $250,000 = a price of $1,000,000. Congratulations. Suppose however you had declared your true revenue: 4 × $1,000,000 = a price of $4,000,000. That $225,000 you saved just cost you $3,000,000. Was that a wink I just saw, or did you get something in your eye? The moral of the story? Be honest, take the high road, and pay your taxes. If you’re looking for a near-term sale, you might want to talk to your CPA about filing some amended returns. If you have time, start doing things honestly (and still have that conversation with your CPA).

Now I can hear some of you saying—I inherited the business from my dad and he always kept his “other” book where he tracked his true income. Can’t I just look for a buyer who “understands” that it is a cash business and show them the “other” book? No! No! No! Aside from the fact that it is dishonest, the buyers will know what you are doing—best case, they will never offer you the true value of your business; worst case, your negotiation could become a blackmail with some unscrupulous characters you don’t want to know.

The owner responds to this situation by telling the potential buyer (with a wink),

“This only shows what we made on the books.”

Yes, that buyer will want to do business with you now that you are an admitted liar and crook. And on that subject:

“Do you really want to do business with a buyer who is willing to accept this type of cheating?”

emma. It’s not likely that buyer will offer you a fair price in any case so again, if you find yourself having this conversation with a potential buyer, you are playing a fool’s game to its end. Fortunately, the solution to this problem is simple. Take what deductions you can legally take and pay your taxes.

Because the buyer also understands that this dichotomy exists, as part of their financial due diligence, one of the things buyers will request are copies of your business’s tax filings for the prior three to five years. The buyer’s negotiation strategy is to get to the lowest possible valuation, and they know you have already driven toward the lowest number when you did your taxes. You did part of their work for them!

The same dichotomy also exists on the expense side of your financials. You have naturally done your best to minimize expenses as you operated your business. When you do your taxes, however, you try to take every possible tax deduction to justify reducing your earnings. Your buyer will want to understand what rationale you used because they may also wish to use it—in their negotiations.

Recasting Your Financials

The next step in financial positioning is to review your financials and recast them to present a realistic valuation of the business. Your financial recast includes making honest, ethical adjustments to achieve a true valuation. Recasting of the financials is needed to determine what the normalized expenses and income are for the business by adjusting the financials to move any expenses or income that will not be normal to the buyers continuing business. Recasting removes any income or expenses that are incorrectly reflected in your financials—meaning eliminating those items in your financials that a new owner will not incur. These are the adjustments made when calculating an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). EBITDA is a common determinate of business value.

In many small businesses, for instance, the owner charges personal expense items to the business. Does the president receive a company car as a benefit? If so, that auto expense will lower the EBITDA if it is not moved below the line. This is a value proposition discussion, not a tax discussion. Remember, the profitability of the business will be used in negotiations to determine the value of your business, so you will want to eliminate any expenses that are not directly required for the operation of the business from the profitability calculation. A similar example may exist for others in the business who will no longer receive some “perks” after the sale.

The same is true on the income side. Did you spin off an asset or offer a product that you received income from, but which will not be part of the continuing business after the sale? That income can be reflected as a valid income adjustment. This is also a good time to have your CPA review what items have been capitalized vs. expensed as well as reviewing the value of deferred sales. Small, valid changes can have a large effect when a valuation multiple is applied, so decisions about these items need to be considered well in advance. This is one of the more critical areas that should be included when you are considering long-term vs. short-term strategic path analysis.

Third-Party Audits

Larger businesses generally involve more complex financial data and a much greater level of analysis than is done for smaller businesses (more product lines or sources of revenue and greater expenses or more employees). As a result, there can be more people involved in the financial operations of the business (more hands touching the financial data) and more room for error (and yes—manipulation). Because of this, and the large sums involved in the deal, buyers may require an audit of the financials by an independent accredited third-party accounting firm. This is common for high value deals.

The greater the value of your deal, the more likely it is that an independent audit will be a requirement and that a buyer will make this a term of your deal. If your financials are complex and will require some level of discussion or explanation, then you are far better off being preemptive and having an audit performed in advance of speaking with a buyer. Paying for an external third-party audit, performed by a reputable accounting firm, will tell a buyer you are serious, and your books have been validated. This lets buyers know that you are also serious about the deal and attempting to provide an honest picture of the business which will save you the time to have an audit performed as part of the buyer’s financial due diligence. But, they may ask to have their own accounting firm perform an audit as well. Don’t resist or complain. Just get it done—this time, at their expense.

Looking Toward the Future

In general, when a buyer looks at your financials, they are looking at the past performance of your business. The number one question any buyer really wants answered however is:

“What is the future potential of this business?”

The person most able to predict the future performance of your business is you. The question may seem like a “crystal ball” question or maybe one for your “Ouija Board.” Keep in mind that your answer may not be definitive, but you are still the best one to give an opinion on this.

“How do I know what the future will bring?”

You may not have insights into things beyond your control (like the economy) or know about some radical innovation in technology that could disrupt the market for your products, and for sure you don’t know what a new owner might do once they control the business. Short of that, you are the person who is best qualified to answer the question. Without using the “crystal ball” or “Ouija Board” methods, your answer may be a guess, but you are qualified to give the best educated guess about the future performance of your business, if nothing external impacts it.

Potential buyers will want to see your future projections, a “pro forma,” early in the process, and you will need to be prepared to defend your pro forma during your initial discussions with potential buyers. If you don’t have a pro forma when they request it, your discussions are likely to end there.

The Sales Projections/Pro forma Chart shown in Figure 7.1 is used to help potential buyers determine whether the business fits into the profile they may be looking for. In the end having this table available will save you from entering into a lot of discussions with people who really aren’t interested in buying your business.

You need to create a pro forma that projects future revenues over the next three years. The most direct method of accomplishing this is to graph the actual past business revenue for at least the past three years, plot the curve of that revenue, and then project that curve forward for at least the next three years. If you have grown 10 percent per year for the past three years, then the curve will show 10 percent growth per year for the next three years. If things were just that simple!

You might have a good reason to believe that the curve will no longer be 10 percent but 20 percent.

“Last year we put in new production equipment that will improve our throughput.”

“Our staff has developed a newer, faster way to operate.”

“An extra 10,000 new homes were just built in the area.”

Each of these could be used as rationale for increasing the trend line and showing improved growth. Let’s face it though—everyone also has bad years. Years when the business performance fell off for reasons beyond your control or which were only temporary.

“Our sales fell off two years ago because the town was widening the highway and our customers couldn’t find parking, but we recovered last year and are back on track now.”

“We lost one of our lead engineers, and it took six months to replace her and delayed the release of our new product.”

“I was out on medical leave for a month and it took time for our new GM to come up to speed, but he has been running the day-to-day operations for the past year.”

Any numbers you present at any point in the process must all match. You can’t show one set of income numbers in one place and a different set elsewhere. If they don’t match, the deal will die quickly. Future projections should always be put in context of the past performance because that makes the numbers more credible.

“I know we have averaged 10 percent growth each of the past years; I think we’re due for a good year.”

Any time your projections deviate from your past performance you will need to be able to offer solid rationale for the deviation. Any time you hear yourself using “I think,” “I believe,” “I feel,” or “my cousin Jake says,” you are not making a rational argument, and your opinion will not be credible.

Figure 7.1 is presented as a table that gives the annual revenue generated by the business for at least the last three years (but preferably the last five if the data exists). The annual expenses and gross profitability can also be added here if they support your rationale. The buyer may not agree with your rationale (and they may disagree to enhance their negotiating position), so keep in mind, the best person to project the future of your business is still you.

The numbers in this table are provided at the “20,000 foot” level, allowing potential buyers to bracket the business to determine whether they have any interest and form a basic understanding of the value of the business. From this they can determine whether the deal will be too small or too large for them. Your goal with these numbers is to bring a potential buyer to the point where they are willing to look deeper.

Draw a timeline in the life of your business from the beginning through the next five years. Financial due diligence will look at the past performance of the business, and operations due diligence will look at the potential sales and marketing performance going into the future. Developing a valid pro forma for the business can be done by extending the timeline into the future and placing your projections onto it. If the business has been struggling, then presenting a hockey stick growth curve will not be believable. If the business has a history of growth and can provide the rationale for continuing that growth with the addition of additional capital, then the growth will be believable. The financial positioning of the business requires showing the continuum of its past performance into the future projections.

Future Performance Should Be Based on a Solid Foundation

Look at the revenue curves in Figure 7.2 (these curves have been greatly oversimplified for the example). If you were a buyer, which of these curves would you be more comfortable accepting? Curve 1 is based on a two-year financial track record and shows that the pro forma projections are a continuation of the businesses demonstrated prior growth rate. Curve 2 doesn’t include any history. Curve 2 says, “trust me, this is where we are today, and this is what I think the business will do in the future.” No offense intended to your great judgment call, but if I’m the buyer, I’ll have more confidence in the continuation of the actual performance demonstrated by Curve 1. If you are able to produce the past performance like that shown in Curve 1 then there is a good chance you can shorten the positioning time. If you don’t have the data, then you have two options: wait one to two years to sell while you collect the data or start working on a truly convincing story as to why Curve 2 should be believed.

This is an example of why it takes time to effectively position a business. You can save the time and take the shortcut, but it will likely impact your sale. It’s time to get busy.

Figure 7.3 is the well-known “hockey stick,” because its shape looks like a hockey stick. While occasionally a business may see radical changes in their growth curves, you are going to have to tell a very credible story to explain your rationale for this type of accelerated growth projection. Causes of this type of growth include the addition of new product lines, added sales staff, or a change in the market. Whatever it is, you will need to be able to justify these radical growth projections to a buyer.

The role your pro forma projections will play in valuing your business will depend somewhat on the type of business. For some businesses the value will be determined based strictly by your past performance. For some businesses, particularly some software businesses, your projections will become strong drivers of the business’s transferrable value. More on valuations in a later chapter. For now, remember that positioning your business includes building believable revenue curves.

There is a school of thought that you should always operate a business as if it’s for sale. I fully support that approach because it means optimizing the operating efficiency of the business and paying close attention to its position in the market. This also has the potential to reduce your positioning activities. In practice, however, it may not be possible to operate your business as if it is constantly for sale, because there may be differences in the long-term vs. short-term strategic approach you use when planning an exit. The argument is that continuing to emphasize a long-term strategy may enhance the value of the business. But, this assumes you are ready to make the same kind of long-term capital commitments to the business as if you intended to operate it long-term, when in actuality you’re looking for a near-term exit. Realistically, you will be trading near-term financial performance against long-term capital improvements, and, unless there is a quantifiable value proposition improvement, it may not make sense to invest in long-term growth strategies.

Would you invest in a larger delivery truck if you’re planning to sell the business? Strategic planning that includes the detailed development and maintenance of a roadmap with key decision points for the business, including both near-term and long-term goals, is an important tool in making these decisions.

Jim’s Bakery Example

Jim’s Bakery provides Jim with a high-end SUV as part of the compensation package he granted to himself. Jim’s rationale for this “perk” is that he uses the SUV to drive between the retail and commercial bakeries and to visit some of his commercial customers throughout the region. Use of the vehicle is a “perk” Jim has enjoyed, but it is clearly more of a luxury he has allowed himself than a necessity to the business. The CFO has regularly deducted the allowable expenses for Jim’s SUV on the financials for Jim’s vehicle on the Jim’s Bakery P&L.

When the Jim’s Bakery financials were being recast as part of the financial positioning in preparation for the sale, the expense for Jim’s SUV was removed as an EBITDA adjustment, lowering the expenses, increasing the EBITDA, and resulting in an increase in the overall valuation of the business. The adjustment was explained to the buyer during negotiations as an acceptable adjustment since the buyer didn’t allow this type of perk for their senior employees.

Jim’s CFO was a strict financial manager who kept detailed records and provided financial reports that were reviewed monthly. Because Jim wanted the financial due diligence to go smoothly and believed it was an opportunity to build buyer confidence, they hired a highly recognized third-party accounting firm to perform an independent audit of their financials.