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Normalising your profits when selling your business

At a fairly early stage in discussions with any party that's interested in acquiring your business, you're going to have to give information on your profits. 

Depending on your size, it could be that your financials are already in the public domain, or they could be reported only a high level of aggregation. Either way, it is very likely that your reported profits are either out of date and are not very illustrative of the real earning power of your business (as would be delivered to the buyer). Tax planning (e.g. paying dividends instead of bonus through payroll), accounting rules, owner compensation and fast growth are just some of the factors that can cloud the picture.

On that basis, it is certainly the case that you are in control of how your P&L is presented to a potential acquirer - and it is well worth spending the time in considering the various assumptions you might make to describe your profits more representatively.

Profit means EBITDA

Step number one - get the discussion focused on EBITDA (your operating profits before interest, taxes, depreciation and amortisation). Your management accounts may not expressly show this line, but it is easy to add and worth doing as it'll be a bigger number than other profit figures you show.  

It is legitimate too - if you have very high borrowing costs or tax rates, these may change under new ownership. EBITDA is neutral to the method of financing the business and to tax jurisdiction. Amortisation is not usually regarded a real business expense - for example, you may carry goodwill from an investment and accounting and tax rules may force the write-down of this over a number of years, but there is a legimate argument that the real value of the asset is not decreasing at all. Depreciation? Many people argue that depreciation is a real cost of doing business, as it relates to the write-down of operating assets, and they are probably right. However, buyers seem to generally accept that depreciation is a legitimate add-back to operating profits for valuation purposes.

Pro-forma accounts

An important first step is to create the accounts for the underlying business that reflects what a purchaser is actually buying. This typically includes eliminating revenue and costs for any discontinued business or business that does not form part of the sale.

Normalisations

The other key set of adjustments you should consider to EBITDA is to normalise the accounts for the profit run-rate a purchaser would expect under their ownership. You can only take this so far at an early stage, but the categories of adjustment include:-

  1. removal of investment costs for new business operations that have not yet produced a return: for example, if you have invested £100,000 in developing a new service line that isn't launched yet, consider adding back this £100,000 to normalised profits
     
  2. appropriate treatment of owner compensation: under new ownership, compensation for the existing shareholders will most likely be through payroll. In your historical accounts, you should normalise profits based on your best estimate of the market compensation package for these individuals. For instance, let's say your current salary is £50,000 but you take a £100,000 profit share through a dividend. You benchmark your salary to market at £80,000. This means you need to adjust EBITDA downwards by £30,000. (This can equally work the other way around - and, in this example, obviously profit after tax is higher).
     
  3. removal of one-off / non-recurring costs: this adjusts profit performance of the business to reflect the underlying performance the acquirer is taking on, albeit 'airbrushed' to remove imperfections. There won't be arguments from acquirers on the validity of some of these adjustments such as transaction costs, others may be questionned (see our check-list below). 

As you can see from the above, the normalisations applied can have either a negative or positive impacts on the profits you represent to a buyer. Self-evidently, any adjustments to reported earnings are subject to interpretation (and negotiation) - there is a balance to be struck between being presenting your results in their best possible light and being overly aggressive (and potentially causing problems later in negotiations).  

Please do let us know if our article is helpful as you approach this subject, or if you have any comments!

'Phil


 

* Check-list of one-off cost categories

This isn't intended to be complete, but might spur some thoughts as you assess whether your business had any non-recurring or one-off costs* that should be added back to your profits:

  1. transaction costs: you're considering a sale, all legal and advisor fees should be non-recurring post sale. This might even extend to resource costs of people working on the sale project, especially if you've backfilled a management position, for example, to allow someone to undertake the work
  2. ordinary non-recurring costs: e.g. office move costs, delapidations, business set up costs
  3. stuff that didn't work: e.g. recruitment costs and salary for people that didn't stay and didn't earn, redundancy / severance costs, legal / dispute costs
  4. things that will definitely change under a buyer: for example, normalising a particularly generous bonus scheme, removal of excess office space rent
  5. costs with exceptional patterns: on occasions, some costs that are normally spread over many years hit the critical periods under scrutiny -  e.g. re-organisation costs, acquisition costs, legal costs for putting in an equity participation scheme designed for a multi-year life, but all hitting in year zero!; maternity cover at exceptional levels

* one of the more aggresive approaches looks at opportunity costs. This is calculating the add-back based the lost margin on missed revenue rather than the direct cost. For example, if a sales director is diverted for six month to support the sale process, the cost add-back might be six months salary. The opportunity cost is materially higher. Good luck if you try this approach!

Published: 03-10-14 by Phil Baxter

small business, company sale, profits