Low Profit Is Not Necessarily A Barrier To High Price When Selling A Business

It's important to get the sale right

How to sell a business for the highest possible price

There are many different ways to value businesses, but the most common is the “Earnings Multiple” where price is quoted as a multiple of annual profits (earnings or 'EBITDA').

For example, if a business is making a profit of £100,000 a year, and other businesses in the same industry are changing hands at a multiple of 6 x profits, it would be reasonable for the owners to go to market with a price tag of 6 x £100,000 or, £600,000.

However, the business owners would probably have been using a number of (completely legal) concessions and allowances in order to reduce annual tax liability and retain more of the profit generated. Such tax mitigation often involves demonstrating a lower level of profit by, for example, depreciating some assets.

They've probably also found tax efficient ways to draw money out of the company, such as paying a spouse a small salary to make use of their personal tax-free allowance.

Tax mitigation is great and everyone should take as much advantage of it as they can, but it has one drawback: it depresses the single most important metric used in calculating business value – the profit.

This is not a problem most of the time, but it’s more than a bit inconvenient when considering the sale of a business.

If tax wasn’t a consideration, the same business in our example above may have shown £200,000 in profit taking the value of the business up from £600,000 to £1.2 million.

So how can one have their cake and eat it too? How can they declare as little profit as legally possible for tax purposes but not have “low profit” negatively influence the value of the business?

Fortunately, there is a way. Unfortunately, many owners of small businesses – businesses with revenue of under £5 million – are complete unaware of it. As a result these owners, even those who have spent years preparing for the sale, end up going to market at the wrong price and losing, sometimes, hundreds of thousands of pounds.

Before we come to the win-win of low-tax and high price, we need to examine why investors buy businesses.

Why do investors buy businesses - the two price-influencers

Investors buy businesses for the return. They risk their capital – because buying a business is always risking capital – in order to gain access to future profit flows.

Two elements play an important part in the price they’re willing to pay: the value (and timing) of the profit they expect in future and their assessment of the level of risk involved in making this purchase.

The lower the risk they perceive in the investment, the higher the price they are able to pay. The higher their profit expectation – based largely on the current earnings chart projected realistically into the future – the more they’ll be able to pay.

Both risk and profit are subjective. One buyer’s estimate of the risks will differ from another’s just as their profit projections will differ. Sellers benefit from influencing their perceptions on either of those.

If the selelr can demonstrate a higher profit, they benefit from increasing the first part of the Earnings X Multiple “formula”.

If they can demonstrate lower risk – perhaps by taking some of it on themselves, which is a topic for a different article –  they increase the latter part of the formula, the multiple (because investors pay higher multiples for lower risk propositions).

So how does one demonstrate that earnings are higher than they actually are? They don’t. They provide, instead, the basis for a different way to calculate earnings.

They “re-cast” their financial statements

Recasting or “normalising” of accounts involves redrafting the accounts from the last few years to reflect the actual financial benefits enjoyed rather than the benefits portrayed in the version submitted to the taxman. It’s completely legal.

While there are numerous rules and laws governing the annual accounts presented to HMRC and/or Companies House, these laws do not apply to any accounts drawn up for the purpose of demonstrating a business’s true value to a prospective buyer.

It's important to present an honest view, but it doesn't have to be one hindered by the numerous reporting restrictions the formal accounts suffer.

How is recasting done? 

A profit statement starts with the revenue / sales at the top - the starting point. From there the cost of goods sold is deducted to arrive at the “operating profit” or "gross profit".

Various expenses are then deducted – from real expenses like salaries and rent to non cash “expenses” such as depreciation and amortisation – till one arrives at the “net profit” right at the bottom.

Recasting, as its very simplest, involves adding back those expenses that didn’t really need to charged in the first place. Each time something is added back, the “bottom line” looks better.

Recasting is the same process as before, but in reverse. One starts with the net profit and keeps adding items back till they arrive at a new profit figure often referred to as an SDE (Seller’s Discretionary Earnings) or EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation).

But adding back needs to be done cautiously. Expenses that a buyer is likely to incur in the running of the business, for example, shouldn’t be added back if the figures are to look realistic and believable.

I advise that recasting is done by the right type of accountant. In this case, it’s not just someone who has professional accountancy qualifications, but one who is experienced with M&A transactions. Here are some of the items an accountant will consider.

1. Personal salaries

How have the owners paid themselves? Salary / dividends /  mileage (or other motoring expenses) / pension contributions? If they paid a spouse or a relative for a “token job”, that salary can be added back.

If they paid themselves more than needed for the work that they did, that surplus can be added back, too.

If they took advantage of mileage payments to make a bit of tax-free income, that’s another opportunity there. The accountant will look at and identify to what extent each of these items, and others, can be added back.

2. Owner benefits drawn

It’s not unusual to have the home phone lines, the home internet connection, mobile phone bills etc., paid by the business. As with membership fees for organisations and trade bodies, business trips (holidays?) and so on.

Where owners work from home there’s often also electricity and gas, rates, insurance and other costs charged to the business.

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

3. Operational costs

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

Products in the warehouse may now be shortage items and command a premium in the market. Or the manufacturer may have increased prices for stock that was acquired relatively cheaply.

Is the business using premises that are too large and did it therefore pay more in rent than it needed to pay?

If the buyer is going to move the company, the “over-paid” rent (and rates) can be added back as those won’t be expenses to which the buyer is subject.

4. Pre-paid expenses

Are the benefits of any pre-paid expenses going to extend to beyond hand-over date? If so these can be added back (a proportion anyway).

5. Capitalising normal operating expenses / inventory purchases

There may be some expenses that, instead of being written off in the current profit and loss account, can be justifiably moved to the balance sheet i.e. capitalised so they can be depreciated in subsequent years – pushing the “hit” to the balance sheet into the future.

(Caution: Large increases in capital expenditure cannot be done at the expense of sharp decreases in operating expenses. One needs to ensure operating expenses continue to look credible.)

Some more ideas on the less obvious costs that could be added back

If employees are part of a salary sacrifice scheme – where they give up a portion of their salary in exchange for equivalent non-cash benefits such as childcare vouchers or pension contributions – that will  result in a lower employer’s National Insurance Contributions (as the employee is earning a lower cash salary). Some of the NICs paid can be added back.

If there's no salary sacrifice scheme, setting one up now would justify adding back a portion of the employer NICs paid in past years.

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

If yes come of the VAT paid can be added back. If the business is eligible for HMRC’s VAT Cash Accounting Scheme – where one accounts for VAT only when an invoice has been paid, rather than when it was issued – there’s a cash flow advantage. If that would reduce the need for external finance it would reduce the interest being paid on that finance and this interest can be added back.

If operating as a sole trader – an often less tax efficient way – one can recast your accounts to show what the position would have been if the business had been registered as a Ltd company.

Reserves for bad debts, warranty claims, pending legal action etc., offer some scope for discretion. Reduce them and it could improve the profit.

Individual circumstances can offer opportunities for additional tweaks – for example, if the owner (or spouse) was born before 1938, or if your business is a farm, there are some specific opportunities that the accountant should know about.

And finally, if one wanted to be very aggressive, one could buy a smaller company. This allows the business to take advantage of what’s called acquisition accounting where the costs of the acquisition come out of the financing section of the cash flow (cash or borrowing) but the benefits – increase in sales and profit – get added to the operating cash flow thereby causing a substantial increase in the bottom line.

Conclusion

When crafting charts, it’s not about deceiving the buyer – that doesn’t work and will only cause a late stage collapse in the deal. It’s about presenting the business in the best possible light using figures, charts (and therefore projections) that can be justified.

Is the exercise worth the time? Remember, that for every £1 added to the earnings, that's  adding £5 or £10 (depending on the multiple) to the price achieved when selling the business

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