For owners who may be thinking about exiting their business in the near future, it is important to know how personal and one-time expenses in the business will impact the value that they will receive. Because the business is worth only what a future owner expects to receive in cash flow from owning the business, it is important to consider the types of expenses an owner runs through the business and how those should be documented for the future owner in order to calculate the true future cash flow.
EBITDA (Recast Cash Flows)—What is it?
In the context of selling your business, it is very important to understand the impact of a consumption mentality. Businesses are usually sold on the basis of “recast” cash flows or EBITDA (earnings before interest, taxes, depreciation, and amortization). The process of recasting the earnings involves adding back one-time or non-recurring expenses, along with personal expenses that are clearly documented. Few owners document their personal expenses each year, and most buyers are unlikely to allow such add-backs without it.
What is a Multiple?
Recast EBITDA is then multiplied by a factor called a multiple. This multiple represents a prospective buyer’s perception of the riskiness of your business and the rate of return he or she requires on the investment in your business. The less risk perceived, the higher the multiple; the more risk, the lower the multiple. Multiples vary by industry, by business, and by size of business, and there are many factors that go into the buyer’s thinking.
Let’s look at two examples of how multiples work:
- Recast EBITDA $1,000,000 X multiple of 5.00 = $5,000,000 potential sale price
- Recast EBITDA $1,250,000 X multiple of 5.00 = $6,250,000 potential sale price
Note that the small difference of only $250,000 in EBITDA at this multiple represents a $1,250,000 increase in potential sale price or business value. So every $1 of earnings equates to $5 of business value.
In addition to having an attractive EBITDA and projections that demonstrate sustainable earnings, other qualitative factors, including the lack of business dependence on the owner, market share, depth of management, processes, procedures, and intellectual property, can impress the buyer, lower the perceived risk and improve the multiple, as in this example:
- Recast EBITDA $1,000,000 X multiple of 5.00 = $5,000,000 potential sale price
- Recast EBITDA $1,000,000 X multiple of 6.25 = $6,250,000 potential sale price
As you can see above, due to the multiplier effect, an increase in the multiple from 5 to 6.25, due only to qualitative factors or lower risk, also represents a $1,250,000 increase in the business value or sale price!
Tax Minimization: Not Always a Best Practice
Focusing on tax minimization by artificially lowering profits can cost you dearly when you sell your business. While many business owners view minimizing taxes, as opposed to tax planning, as being their CPA’s most important function, it’s not a great idea when it comes to the sale of a business. Minimizing taxes by artificially lowering profits can cost you a staggering amount during the sales process i.e. $5 for every $1 of lost profit, using our example above.
In an effort to pay the minimum amount of taxes, many owners run “lifestyle businesses.” By that, we mean the owner seeks to take as much money as possible out of the business in order to fund the family lifestyle and keep his/her tax burden to a minimum. Unfortunately, this money is usually spent on an increasingly expensive lifestyle and is rarely saved for the owner’s future needs. This is actually just a form of consumption, rather than the creation of wealth, which would occur if the business were treated like an investment.
If you have been treating your business as a lifestyle and some of your value drivers are not up to par, it may take years to sufficiently correct these factors and maximize your business value. With ample time and good advice, most businesses can greatly improve their opportunities for selling and increase the value they will receive.
We strongly recommend that owners seek comprehensive, holistic advice in preparation for any sale, whether internal or external. There is no substitute. If this is a once-in-a-lifetime transaction for you, you cannot afford to make a costly mistake.
