You’ve been thinking about what to do with your business. Is everything running the way that you like, or does something need to change? Did you stop growing years ago, or has a major customer started working with one of your competitors? Or is profitability down and back office costs out of control? Then you might be asking yourself if it is time to revamp your firm or sell. Before you look into a valuation for your firm, you need to be sure that the data you will use for that valuation is reliable. Surprisingly, many family run small businesses have a lot of problems in producing a clean set of numbers for an accurate valuation. Why is it so difficult for small businesses to produce reliable financial documents? Well, you could say that the problem is… ahhh… relative.
Every firm has different challenges, but family run businesses have special issues. When a buyer is interested in buying a small business that is completely run by the owner, the valuation is likely to be low. This type of “one man show” has a lot of risks. All the functions of the firm… sales, business development, operations, customer satisfaction… are managed by just one person. If anything happens to that one person, not much is left to the purchase. That’s why a one person operation is penalized in the valuation. A larger firm with multiple family members can spread the risk around by having key positions occupied by multiple individuals, even when they are all related.
However, this benefit also has a downside. How are you paying those relatives? Often the answer is, “Through hidden payments.” You pay some family members through salaries, and other payments may be hidden throughout the firm’s operations. When workers are family members, the family is willing to approve unorthodox payments.
As long as you keep within the bounds of common sense, this is rarely illegal. However, this practice almost always lowers the profitability of your business, which always results in a lower offer for your firm. It can also create issues of trust (and credibility) between you and the buyer. Usually, you can explain why there is a difference between your tax filings and your “real” profitability. You can credibly explain to a buyer that the numbers on your tax returns are not a complete view of your firm’s finances. But, if you repeatedly change the numbers, you will undermine that trust.
If you never sold a firm before, you will find that it takes longer than you expected to get realistic numbers to your buyer. It is not unusual for your tax filings to show a profit that is under-reported by as much as 10% to 50%. That means that if your valuation is based on profitability (or EBITDA or anything similar), your offer will be proportionately reduced. Let’s take a look at the most common expenses that get “stuffed” in the wrong expense categories and what you can do about it.
- Payouts: A family business often pays members of the family from firm profits. In an attempt to reduce taxes, families often redefine payouts as expenses or other forms of payments. This can be done legitimately when legitimate work is performed, but it is often abused or at least poorly tracked. If you carefully track these payouts, it makes it a simple task to present a real net profit number to a buyer. Documentation is important! While some family businesses issue shares to the family, other businesses have a freewheeling process of directing payments to the family. Documenting how the family is paid goes a long way to explain last year’s tax return, and a map of payments (and voting shares?) reduces last minute debates about the conditions of the sale.
- Compensation: Members of the family may be full-time, fully documented and taxed employees. That shouldn’t be a problem. As long as you pay market rates. It’s perfectly legal to overpay your brother-in-law. If a position could be filled for $40,000, you might pay a more generous salary to a relative and provide extra benefits that have a total cost of $100,000. That hurts your valuation. After you sell, will your brother-in-law still have this job? If he does, will he be brought down to market pay? You need to identify intentionally overpaid positions and know if you would advise a buyer to adjust, eliminate or re-staff these positions.
- Cars: One of the most significant “family” charges are for car leases. It is reasonable to charge one or two leases to the business (the president and sales manager?), but a family owned business might have many more cars billed to the firm. You need to keep track of all car leases, mileage expenses, repairs and any other car related expenses. How many cars will the buyer pay for after the buyout? That may be a critical issue for your valuation.
- Memberships, Travel & Expenses: All sorts of expenses are hidden in your Profit and Loss statement, like club memberships. Golf course memberships can be very expensive. A retired family member might charge one or more of these memberships to the firm. You may even make occasional use of a membership to entertain your customers. Is the benefit worth the cost? If it isn’t, track this and make it clear to the buyer that this expense will not continue after the buyout. Also, check carefully for lunch, dinner, taxi’s, and travel/hotel expenses that are not company related.
- Office Expenses: Not surprisingly, this can be a dumping ground for unclassified expenses. Very carefully examine the expenses and identify all family related expenses.
As you prepare your firm for sale, you need to make a shift from avoiding taxes to maximizing valuation. Small businessmen normally look for every possible tax deduction. Many of these expenses will be perfectly legitimate. But when you choose a relative to do the work… are you paying more than you would pay to a non-family member? Let’s be honest, this generosity is mutually beneficial. The head of a family business is often also the head of a family. The family head is expected to help young family members find an entry level job and provide financial aid to retired family members. But these tasks that fall to the head of the family are fulfilled by the head of the business. Also, these (over?) payments minimizing taxes, so it is easy to think that you’re more or less breaking even. Until you find out how it impacts your valuation.
The best solution is to start tracking and documenting these expenses BEFORE you try to sell your firm. Take a look at the amount of unnecessary or non-recurring expenses in last year’s profit and loss. It may be an eye-opening experience. You might even decide that you need to start being more critical of family expenses. At least, that’s my Niccolls worth for today! If you don’t agree or if you have your own ideas on this subject, comment and let’s talk about it! If you are planning to sell your firm and you need help in addressing valuation (or finding a buyer), just connect with me and we can have a confidential discussion!