Playwright Oscar Wilde observed that “only shallow people don’t judge by appearance.” This facetious remark is actually quite valid when it comes to the sale of a business. The appearance of your company — particularly the presentation of your financial statements — can very well determine whether you receive a fair market price.

Often, the financial statements of small and mid-sized businesses misrepresent a company’s profitability because various accounting methods are used to reduce income and minimize taxes. Also, owners and family members may receive compensation and other perks that cut into reported profitability. An M&A advisor will therefore usually recommend “normalizing” or adjusting financials when you prepare your business for sale.

Accounting for Differences

Normalizing entails changing the level of expenses and revenues your business has been reporting to what a buyer might expect after acquiring your business. Many small businesses employ the cash method of accounting, which recognizes income when cash is received and expenses when bills are paid. But the accrual method of accounting — reporting income when it’s earned and expenses when they’re incurred — is more common among larger companies and may present your company’s financials in a better light.

Your system of reporting depreciation may also harm the look of your business. If you currently use an accelerated schedule to depreciate assets, your advisors might recommend you instead spread your depreciation expense over a longer period, as potential buyers would.

Compensation and Perks

Owner-operated businesses often compensate owners and other family members at higher levels than other
companies pay their key executives. Buyers who no longer need to compensate an owner or may not wish to pay executives as generously would, therefore, expect lower expenses allocated to salaries and bonuses. And because the company’s normalized payroll would be lower under different ownership, the firm’s assumed payroll tax would be adjusted as well.

Perks enjoyed by business owners — including company cars, club memberships, entertainment, luxury hotels and dinners — may also need to be eliminated on normalized statements. Financial advisors adjust these expenses by eliminating anything a new owner might regard as excessive or unnecessary and place them in line with industry norms.

Some business owners include their spouses and other family members under their company insurance policy coverage. Because a buyer presumably wouldn’t maintain this generous coverage, insurance costs would be normalized into a less comprehensive, standard coverage plan.

Other Adjustments

Other items that might merit the attention of your financial advisors during the normalization process
include:

• Inventory – Businesses often record inventory sales using the last in, first out (LIFO) accounting method. Given that the cost of inventory usually increases over time, the LIFO method more quickly reflects these recent increases as cost of goods sold, resulting in lower reported profits and lower taxes. Restating earnings with the first in, first out (FIFO) method makes for more robust profits and is generally recommended if you are trying to sell your business.
• Interest expenses – If your business has bank loans or bonds outstanding with varying interest rates, a new buyer might be able to consolidate this debt with a lower overall rate. A normalized income statement would reflect potentially lower interest expenses.
• Real estate leases – If your company leases real estate from another business you own, the lease may be set at an above-market rate to maximize your real estate earnings. Advisors normalize the cost of the lease to reflect the fact that a new owner would likely pay only a fair-market rate to lease the property.
• Related-party transactions – Similarly, your business may be overpaying certain vendors or undercharging particular customers because of personal and family relationships that would not apply under different ownership. These items would also be adjusted to going market rates.

Realistic and Appealing

As a business owner interested in selling your company, be prepared to work with your M&A advisors to reshape your company’s financials into a format that is useful to buyers. When you successfully normalize your financial statements, not only is a more realistic picture of your company likely to emerge, but a more appealing one as well.

For more information, contact a Doeren Mayhew Capital Advisor M&A advisor.