When selling businesses, a low profit is not always a barrier to a high price

There are many different ways to value companies, but the most common is the “earnings multiple,” where the price is expressed as a multiple of annual earnings (profit or “EBITDA”).

For example, if a company makes a profit of £100,000 a year and other companies in the same industry change hands at multiples of six times that profit, it would be reasonable for the owners to enter the market at a price of 6 x £100,000 or £600,000.

However, the entre­pre­neurs would probably have used a number of (entirely legal) conces­sions and benefits to reduce the annual tax liability and keep a larger share of the profits generated. Such tax reduction often involves demon­strating a lower level of profits, for example by depre­ci­ating some assets.

They’ve also likely found tax-efficient ways to get money out of the business, such as paying a spouse a small salary to take advantage of their personal tax allowance.

Tax breaks are great and everyone should take advantage of them as much as possible, but they have one downside: they reduce the most important metric for calcu­lating business value — profit.

In most cases this is not a problem, but it is more than incon­ve­nient when thinking about selling a business.

If taxes were not an issue, the same company in our example above might have made a profit of £200,000, increasing the value of the company from £600,000 to £1.2 million.

So how can you have your cake and eat it too? How can you claim as little profit as possible for tax purposes without “low profit” having a negative impact on the company’s value?

Luckily there is a way. Unfor­tu­nately, many small business owners – businesses with a turnover of less than £5 million – are completely unaware of this. This means that these owners, even those who have spent years preparing to sell, end up entering the market at the wrong price, sometimes losing hundreds of thousands of pounds.

Before we get to the win-win situation of low taxes and high prices, we need to examine why investors buy companies.

Investors buy companies because of the returns. They risk their capital — because buying a company always involves risking capital — in order to gain access to future profit streams.

Two elements play an important role in the price they are willing to pay: the value (and timing) of the expected profit in the future and their assessment of the risk associated with this purchase.

The lower the risk they have perceive The higher the price of the investment, the higher the price they can pay. The higher your profit Expec­tation – essen­tially based on current earnings perfor­mance realis­ti­cally projected into the future – the more they can pay.

Both risk and reward are subjective. One buyer’s risk assessment will differ from another, just as their profit forecasts will differ. Sales­people benefit from influ­encing their percep­tions on any of these points.

If the seller can show a higher profit, he benefits from the increase in the first part Result x multiple “Formula”.

If they can demon­strate lower risk — perhaps by taking on some of it, which is the subject of another article — they increase the final part of the formula, the multi­plier (because investors pay higher multi­pliers for lower-risk proposals).

So how can you prove that the income is higher than it actually is? They don’t do that. Rather, they form the basis for a different way of calcu­lating income.

The recasting or “normal­ization” of the accounts involves a recasting of the accounts of recent years to reflect the financial benefits actually enjoyed, and not the benefits presented in the version submitted to the tax office. It’s completely legal.

Whilst there are numerous rules and laws governing the financial state­ments submitted to HMRC and/or Companies House, these laws do not apply to financial state­ments prepared to demon­strate the true value of a business to a potential buyer.

It is important to present an honest view, but one that does not need to be hindered by the many reporting restric­tions that formal accounts are subject to.

A profit and loss statement starts with sales/revenue at the top – the starting point. From there, the cost of goods sold is subtracted to determine “operating profit” or “gross profit.”

Various expenses are then deducted — from real expenses like salaries and rent to non-cash “expenses” like depre­ci­ation — until you get to the bottom of “net profit”.

In the simplest case, the new version involves the re-addition of expenses that did not have to be calcu­lated in the first place. Every time something is added, the “end result” looks better.

Recasting follows the same process as before, but in reverse order. You start with net profit and keep adding items until you reach a new profit number, often referred to as SDE (Seller’s Discre­tionary Earnings) or EBITDA (Earnings Before Interest, Tax, Depre­ci­ation and Amorti­zation).

But counting back must be done carefully. In order to make the figures appear realistic and credible, expenses that a buyer is likely to incur in the course of business opera­tions should not be included.

I recommend that the recast be done by the right type of accountant. In this case, it is not only someone who has profes­sional accounting quali­fi­ca­tions, but also someone who has experience with M&A trans­ac­tions. Here are some of the points an accountant will consider.

How did the owners pay themselves? Salary / dividends / mileage (or other travel costs) / pension contri­bu­tions? If they paid a spouse or relative for a “dummy job,” that salary can be added back.

If they paid themselves more than was necessary for the work they did, that excess can also be added back.

If they use mileage payments to earn a little tax-free income, that’s another option. The accountant reviews and deter­mines the extent to which each of these and other items can be added back.

It is not uncommon for the company to pay for home phone lines, home internet access, cell phone bills, etc. As with membership fees for organi­za­tions and trade associ­a­tions, business trips (vacations?) and so on.

When owners work from home, there are often also electricity and gas costs, tariffs, insurance and other costs that are billed to the business.

Wherever expenses are required to enable the new owner to continue running the business, the accountant will leave these in, but many business owners are often surprised at how much can be added back under this heading.

Is inventory worth more than book value? It’s not just the wine that gets better with age.

Products in stock may now be shortage items that command a premium in the market. Or the manufac­turer may have increased prices on inventory that was purchased relatively cheaply.

Does the company use premises that are too large and has it therefore paid more rent than necessary?

If the buyer wants to move the business, the “overpaid” rent (and fees) can be added back as these are not costs that the buyer has to cover.

Will the benefits of prepaid expenses continue beyond the handover date? If so, these can be added back (at least a share).

It may be that there are some expenses that are not written off in the current profit and loss account, but can rightly be moved to the balance sheet, i.e. capitalized, so that they can be written off in subse­quent years — thereby moving the “hit” on the balance sheet into the future.

(Caution: Large increases in capital expen­diture cannot occur at the expense of large reduc­tions in operating costs. It is important to ensure that operating costs continue to appear credible.)

When employees partic­ipate in a salary sacrifice program — where they give up part of their salary in exchange for equiv­alent benefits in kind, such as childcare vouchers or pension contri­bu­tions — this results in lower social security contri­bu­tions from the employer (as the employee earns a lower cash salary). Some of the paid NICs can be added back.

In the absence of a salary sacrifice scheme, the intro­duction of such a scheme would justify repaying a proportion of employer NICs paid in previous years.

Do an exercise and see if it is worth paying less VAT under the VAT flat rate.

If so, the VAT paid can be added back. If the business is eligible for HMRC’s VAT cash accounting system — where VAT is only accounted for when an invoice has been paid, rather than when it has been issued — there is a cash flow benefit. If this reduced the need for external financing, the interest paid on that financing would also decrease, and that interest can be added back.

If you operate as a sole proprietor — which is often less tax efficient — you can restructure your accounting to show what the situation would have been if the business had been incor­po­rated as a limited liability company.

Provi­sions for bad debts, warranty claims, pending legal disputes, etc. offer a certain degree of discretion. Reduce them and it could improve profits.

Individual circum­stances may present oppor­tu­nities for additional optimization — for example, if the owner (or spouse) was born before 1938 or your business is a farm, there are some specific options the accountant should be aware of.

Finally, if you want to be very aggressive, you could buy a smaller company. This allows the company to use the so-called acqui­sition accounting, where the costs of the acqui­sition come from the financing part of the cash flow (cash or loans), but the benefits — an increase in sales and profits — are added to the operating cash flow, resulting in a signif­icant increase in the bottom line.

The point of creating diagrams is not to deceive the buyer — it doesn’t work and will only lead to a later deal failure. It’s about presenting the company in the best possible way using justi­fiable figures, diagrams (and therefore forecasts).

Is the exercise worth it? Remember that for every £1 added to earnings, £5 or £10 (depending on the multiple) is added to the price realized when the business is sold

Do you need tailored advice relevant to your business? Want advice on recasting your accounts?

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