Many business owners and their accountants do as much as they can, within the IRS rules, to suppress profitability in order to retain as much as possible, within reason, and pay as little as possible to Uncle Sam. There is nothing illegal or immoral about this; it is in some ways encouraged by the way our tax code has evolved.
Having said that, over the years, this can paint a far different picture about the true profitability of the business. Many business owners we encounter have forgotten the myriad of ways their CPAs and accountants have “experimented” with the numbers. The reality is because of this, your company’s actual earnings could be far lower per your books than they really are.
So why does that matter? Simple = if you approach buyers without recasting or restating your earnings, you could be, and most likely will be, radically undervaluing your company.
Business owners often overlook this vital step in pre-marketing preparation, which is why it is so fantastic to hire a professional M&A advisory firm like Generational Equity to work with. Our first step, before even considering approaching buyers, is to complete a thorough, detailed and complete evaluation on our client’s business.
This does two things:
Major caveat moment: Recasting is HARD WORK.
Odds are really good that unless you have a degree in accounting, you will not be able to accomplish this on your own. You will need accounting help. Trust me. Even if you hire us, it will still require your time because we will ask you lots of questions (our preliminary worksheet that we send our clients to start the process typically runs 25-30 pages in length). Some folks become daunted by the topics we delve into and many, if they are not using their accounting folks to help them due to confidentiality issues, put the process on hold for months in order to accurately address our questions.
If you hire us and are stuck on page 4 of the worksheet we send, pick up the phone and talk to your evaluation associate or valuation manager. Typically, with their guidance, the key questions can be covered in a couple of phone conversations, and the process of recasting can be relatively painless. Don’t get caught up in the quagmire – reach out to us.
The second caveat I provide is this: Not all recasting has a positive effect on earnings.
For example, let’s say you have not been paying your VP of production a salary at a fair market level because he is your cousin. We may need to reflect the salary that a non-family member can command and that would possibly reduce your future profit margins a bit. However, by and large most items that are restated and reformulated have a positive impact on earnings.
You may be wondering what these magical recast items are. Every company is unique in this regard but in general the following items are typically recasted:
Believe me, this is just a short list of items that we often are able to adjust. But it can include much, much more.
Recasting, or financial statement adjusting, eliminates from the historical financial presentation items that are unrelated to the ongoing business, such as superfluous, excessive, or discretionary expenses, and nonrecurring revenues and expenses. Recasting provides an economic view of the company as though it were run by management dedicated to maximizing profitability and allows meaningful comparisons with other investment opportunities.
The last segment of that paragraph sums up why you need to accurately restate your earnings historically: Buyers are going to be comparing your business to lots of other opportunities. And what are they using in their analysis? Historic financials AND projections of the future that are based on your historical numbers. Keep in mind that as important as your history is, what buyers are really interested in is your company’s future growth and earning potential.
If the five-year pro forma you provide them in your offering memorandum DOES NOT start with a base year created using recast history, then you will be understating your valuation. Trust me, buyers love it when sellers do that.
Carl Doerksen is the Director of Corporate Development at Generational Equity.
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