Income Reporting And Selling Your Business

“The Double Edge Sword Of Creative Accounting And Business Valuations”

One of the classic problems buyers have when trying to get business financing or acquisition financing for a business they want to purchase, is that the financial statements don’t accurately reflect (or easily reflect) the true profitability of the company or the amount of net cash flow future owners will have available to them.

This is because the seller disguised his or her drawings with expense items that don’t clearly show whom the benefactor was of the cash paid by the company.

Whether the expenses are legitimate deductions or not are another matter.

But the seller’s tax planning (or tax avoiding strategy) ends up showing a picture where the company’s profits are minimal to avoid paying corporate or business income tax.

To compensate for this historical approach to tax planning, I’ve seen different sellers prepare their last completed fiscal year end financial statements prior to putting the business up for sale to show a significant profit in the hope that this will be sufficient evidence of true profitability for the buyer and potential third party sources of debt financing.

And while the buyer may be convinced of the real cash flow via the last year’s numbers alone,  sources of business financing will likely remain skeptical.

Its not unusual that for an acquisition loan, a lender will ask for five or six years of the seller’s past financials to gain a better understanding of the profit and cash flow trend line.

Business brokers will call me and explain how they have “recast the financials” to more accurately show how much disposable income is available for debt service and owner drawings.

While on the surface, I have no doubt there is credence to these numbers, there are unsubstantiated by an unbiased third party and will likely not be considered by a lending source unless third party verification comes into play.

This is can be a real dilemma for the seller in that if he or she was tax planning in the grey area, they don’t want anything documented that could come back to haunt them.

But if the financial statements as written do not provide sufficient support for debt servicing, then it can be difficult to sell the business as buyers requiring financing (which tends to be most buyers) will have a hard time putting the necessary capital together.

Its hard to say what the best approach is as ultimately the goal of the seller is to pay as little income tax as possible before and after the sale of the business.

This is where the business finance aspect of your exit strategy comes into play.

Its well advised to think through all potential scenarios for selling two or three years in advance of putting the business up for sale.

In order to achieve an optimum sale price, solid cash flow is going to be required to prove out any cash flow multiplier.

Choosing a tax strategy that provides minimal if any taxable earnings may not only lend to a much lower potential selling price, but it may leave the seller as the only financing option for the purchase if third party financing is required.

The key to developing a proper exit strategy is to work with an experienced business finance professional who can work through the various potential scenarios with you so that a path with a higher probability of success (and lower probability of tax) can be laid.

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