Earnings drive business value more than any other factor when selling your business. However, if you can’t prove the earnings with solid business financial statements, much of that value is lost. A business has little value without proof of revenue.

It is important to have the following readily available if used in your business:

• The last three years of business tax returns, filed and up to date.
• The last three years’ profit and loss statements that closely match the tax returns or can be explained.
• Inventory and accounts receivable (A/R) aging reports.

Calculating Discretionary Earnings 

As stated above, earnings drive value when selling your business. More specifically, Discretionary Earnings (DE) drive the value of a business. DE is the total (provable) economic benefit an owner derives from the business.

To calculate DE, a professional business broker or valuation analyst starts with the business’s tax return net profit and adds back EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), plus all owners’ salaries, benefits, and one-time expenses.

For an expense or benefit to be added back as an owner’s discretionary item, it must appear on the tax return, be provably non-essential for ongoing business operations, and be genuinely an owner benefit or discretionary expense.

Legitimate Owner’s Benefits 

Several legitimate business expenses can be expensed by the owner, including travel and entertainment, auto expenses, health insurance, life insurance, and pension contributions.

Your CPA should discuss all the options available to you when selling your business to ensure you are doing this properly and within IRS guidelines, as well as making sure they are documented properly. Done correctly, all of these expenses can be added back as owner benefits when selling a business.

Unreported Income and Inflated Expenses 

Some sellers unwisely and shortsightedly opt to hide revenue and earnings when they are preparing to sell their business by not reporting cash transactions, shifting end-of-year revenue into the next year, or inflating expenses to reduce earnings.

While this reduces taxes in the short term, it will also dramatically reduce the value of your business when you sell it. To put it in perspective, consider this: the majority of businesses are valued between two to three times their Discretionary Earnings (DE).

Thus, for every dollar of reduced provable DE, the value of the business decreases by two to three dollars. So if a business owner buried, say, $100,000 of cash income or inflated expenses that they could not prove were unrelated to the business, the value of their business would be reduced by as much as $200,000 to $300,000.

Use Smart Tax Planning 

This does not mean you have to pay higher taxes. It just requires you to work closely with your CPA to find ways to legitimately reduce your taxes. Even when selling a small business, you can minimize your taxes and still maximize its value by following proper accounting methods and good tax planning.c

Revenue and earnings growth also drive value, as well as increasing the marketability of the business you’re selling. Obviously, a rapidly growing business will have a higher value than a similar business with flat or declining sales.

In fact, a business with declining sales is discounted during normal valuation, while a growing business generally obtains a premium.ad

Businesses that are highly dependent on the owner are difficult to sell and often result in their value being discounted. Through staff training, delegation of day-to-day tasks, succession planning, and a good exit strategy, you can minimize your business’s dependency on you.

Of course, some responsibilities cannot and should not be delegated, and buyers respect and understand this. The key is to create a business that does not rely solely on you as the owner, and your role is that of an owner/manager, not the key employee for all day-to-day tasks.

As stated above, having a business that is not totally dependent on the owner is vital. Thus, if you’re preparing to sell your business, it is important to have well-trained employees who can handle the day-to-day operations.

Having supervisors and administrators is a big plus, and having experienced employees with a solid tenure with the company is also very helpful. Having employees does not add a specific dollar value to the value of the company, but it does make it much more marketable and ensures the company value will not get discounted due to owner dependency.

Established procedures are a big plus for the marketability of a company. Again, this is an area that does not directly affect value when you’re selling your business, but it definitely affects marketability as the buyer recognizes that the transition will be smoother and the risk of business ownership will be lower.

Customer concentration is another item that can reduce the market value and marketability when you sell a business. For example, if your company has a single customer that represents a substantial part of your business, say 50% or more, this may affect your company’s value and marketability.

However, it depends on the situation. Companies with several large customers are fairly common, and as long as the track record with these clients is solid, it does not generally affect the value of your business.

Another way to add value to your company is through tax planning. Tax planning will not increase the market value of your company, but it can dramatically increase the amount you retain after taxes.

If you want to sell your business, we highly recommend discussing tax planning with your CPA and/or financial advisor to ensure you have a plan to minimize the taxes on the sale. Our firm works with several tax strategy CPAs and financial advisors who offer free consultations to review tax strategies to minimize and defer the taxes if you’re selling a business in California.

Contact us to arrange an appointment with one of the tax and financial advisors we work closely with. We do not accept any referral fees from the financial and tax advisors we refer our clients to.