GAAP versus Cash Basis for Selling a Business
When considering a sale, it makes sense to do an annual compiled financial statement that is presented on a GAAP basis versus Cash Basis, which is commonly used to report Income on a your tax return. This GAAP financial can then be used for valuing and selling your business compared to using Tax Returns.
The reason for this is you do everything you can to minimize your tax burden. This includes prepaying for expenses, buying inventory at year-end, buying equipment at year-end, etc. to employ tax saving strategies as advised by your tax professional or financial planner.
When preparing to sell, it makes sense to hire a CPA to do a Compiled Financial Statement on a GAAP basis. Why? GAAP tend to normalize income and increase Net Income which increases EBITDA. For example, companies on the NYSE that are publicly traded report on a GAAP basis because it tends to show more Net Income. As a business owner, you learn this the year you are forced to go from a Cash Basis Tax Return to an Accrual Tax Basis Return because you generally pay more taxes in the year you switch over because your taxable income increases. For this reason, taxpayers like to stay report on a Cash Basis for taxes as long as they can or until they are forced to do an Accrual Method by the IRS when they have $5 Million a year in average Gross Revenue.
When you are ready to sell, if you will have a GAAP basis Financials prepared, chances are, you will get more for your business and put more money in your pocket.
Valuing an Orthodontics Practice
When valuing an Orthodontics Practice, two important considerations need to be made:
- Accounts Receivable.
- Accrual versus Cash Basis Accounting.
When valuing an Orthodontics practice, especially if it is a startup and less than 2 years old it is important to consider Accounts Receivable in the valuation equation. For instance, when valuing an orthodontics practice, they typically have AR that can stretch out 24-30 months. If you are using cash basis financials, it is important to subtract out beginning AR and add in ending AR to gain a true reflection of actual revenue
Calculation from Cash Basis Accounting to Accrual Accounting is as follows:
Revenue $1,500,000
Cash Basis Cash Flow $400,000 $400,000
Add: Ending AR $375,000 $375,000
Less: Beginning AR ($179,000) ($179,000)
Equals Accrual Basis Cash Flow $596,000 $2,096,000
Adding back the change in Accounts Receivable to Cash Flow and Revenue reflects a more correct picture of Cash Flow and Revenue. Orthodontics practices are unique due to the fact that their AR may stretch out for 2-3 years, so it is an important consideration to make when valuing an Orthodontics practice.
Beware: A Self-input Business Valuation is not a good idea
There is a type of business valuation software and service available that allows a business owner to input their own financial information. Although this may seem like a good idea, it is a very bad practice. Valuations, like tax returns are complicated and require a seasoned professional to analyze and input the data to get an accurate number for value. One of the main reasons that a business owner would not want to do the valuation themselves is there are key expenses that can be added back into the EBITDA and Cash Flow calculation. If these expenses are missed, the valuation number is inaccurate.
Key add backs and charges tend to be buried in the tax returns or financials and are easily missed. These include:
- Amortization Expense, which is usually shown on the Schedules and buried in the tax return.
- Section 179 Depreciation Expense, which is usually shown on Schedule K-1 of the Tax Return and erroneously added back with the rest of the depreciation.
- Partner Wages and cost to replace the owners for a situation where there is multiple partners who own a business.
- Cost of a working spouse who is not paid.
- Adjusting the lease to the market rate.
- Correct calculation of SDE, EBITDA.
- Repair and Maintenance Expenses that need to be capitalized.
- An S-corp tax return will show more Taxable Income (Net Income) than the P&L due to the expenses and pass through items on the Schedule K-1’s. If the business owner doesn’t understand income and pass-through entity taxation, he will undervalue the business.
- Schedule M-1 on the Tax Return contains important information and business owners tend to not understand how Schedule M-1 works.
Business Valuations are exponentially more accurate if a Valuations Expert or CPA gathers, assimilates, and inputs the critical information pertinent to the engagement to get an accurate value for the business.
The second consideration applies to financial advisors who refer clients to a third-party valuation service and allow their clients to input sensitive financial information themselves. One main reason for a Financial Advisor to not want to refer a client to a self-valuation service like BizEquity is the client’s data is captured by the provider and that data is sold to competitors. Financial advisors often pay for the service, send clients to the service provider, and their clients’ personal financial information is resold by the business valuation service provider to anyone who wants to purchase it. It doesn’t make sense to give competitors sensitive client information, especially when an advisor is paying for the service.
I recommend that a business owner contact a knowledgeable valuation expert who is an independent third party to get an accurate estimate of value for their business. If a client inputs the financial information themselves it is highly likely to produce an inaccurate value for the business.
How to register a new business and get an EIN
I get a lot of requests from Buyers who need to register and start a new business in Utah. This includes getting an EIN, picking a name, etc.
Here is what you will need to start, register and license a business in UT.
1. Pick a name and register it. https://secure.utah.gov/bes/
2. Get an EIN. Go to: https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
3. Register your entity with the State of UT. This site will walk you through the process. https://secure.utah.gov/osbr-user/user/preoption1.html?beginRegistation=Begin+Registration&_csrf=a8761e29-dfec-4241-911c-e61e35d5f5e0
The State has a boiler plate set of Articles of Incorporation/Organization, but I would suggest finding a good attorney to help you with that and a good Operating Agreement, particularly when there are partners who are involved. If you need one, I can suggest one that I have used in the past.
Adjusted EBITDA or EBITDA? – Part 3 of 3
Now that you can calculate EBITDA correctly it is time to drill down into the difference between Adjusted EBITDA and EBITDA. Before we review this important distinction, I think it is important to explain the reason for using another benchmark for valuation.
If you classify businesses as small, medium or large, breaking them up into categories based on sales, it would be safe to categorize lower-midmarket businesses in the following ways:
- Small sized businesses have less than less than $1 Million in Annual Revenue or Sales.
- Medium sized Businesses have between $1 Million to $20 Million in Annual Revenue or Sales.
- Large sized businesses have >$20 Million in Annual Revenue or Sales.
These categories of businesses are each represented by different types of advisors. Business Brokers do a great job selling the small businesses. Investment Bankers do a great job selling large sized businesses. Medium sized businesses are often represented by Brokers or Investment Bankers. The problem lies in the fact that there is a big difference between selling a mom-and-pop sandwich shop and a $15 Million Manufacturing business. Brokers who aren’t experienced in Mergers & Acquisitions have a hard time selling medium sized businesses due to these differences. There is also a big difference between selling a $40 Million-dollar Internet business and a $3 Million distribution business. For the same reasons, Investment Bankers have a hard time selling medium sized businesses. It doesn’t quite fit into their model. For these reasons, I believe, we have differing opinions about what EBITDA is and the need for ADJUSTED EBITDA to be calculated.
For example, let’s use a simplified example to explain the problem. A small business usually has an owner-operator who runs the business. For these businesses SDE (Seller’s Discretionary Earnings) is the most important number to use to assess as an income multiplier of value. The reason SDE is used is the buyer of the business is most likely to run the business himself and replace the owner and his function.
With a medium sized business, the new owner may or may not replace the current owner. The current owner may have a manager in place to run the day-to-day operation and not need to be replaced. If this is the case, then EBITDA or ADJUSTED EBITDA would be more a more relevant income multiplier of value.
Larger sized businesses rarely have an owner operator who will be replaced so EBITDA is the best revenue multiplier to use for valuing the company. It is the medium sized businesses that have the most problem with what multiplier to use for four reasons:
- SDE and EBITDA both may need to be applied as an income multiplier for a fair valuation.
- EBITDA doesn’t always paint a true picture of cash flow if the current owner of a business needs to be replaced after the business is sold.
- Discretionary expenses (perks) are not accounted for in the EBITDA Calculation. In many medium sized businesses there are discretionary expenses that should be added back to income since they will no longer be an expense for the new owner of the business.
- One-time losses and Revenue are not accounted for in a simple EBITDA calculation.
- Lease expense over or under market isn’t accounted properly when the current owner of the business owns the real estate that the business is leasing.
For this reason, the new market practice is to use ADJUSTED EBITDA. Adjusted EBITDA is calculated as follows.
| Annualized | ||||
| 2015 | 2016 | 2017 | ||
| Income | Revenue | $2,000,000 | $2,200,000 | $2,500,000 |
| Pretax Income (loss) | 225,000 | 425,000 | 625,000 | |
| Expenses | Depreciation | 26,000 | 25,000 | 25,500 |
| Amortization | 4,000 | 4,000 | 4,000 | |
| Interest | 16,000 | 16,000 | 16,000 | |
| Unadjusted EBITDA | $271,000 | $470,000 | $670,500 | |
| Owner Compensation | ||||
| Wages of Owner | 175,000 | 175,000 | 175,000 | |
| Payroll Taxes – Owner | 10,718 | 10,718 | 10,718 | |
| Health Ins – owner | 10,000 | 10,000 | 10,000 | |
| Life Insurance | 4,000 | 4,000 | 4,000 | |
| Automobile | 6,000 | 6,000 | 6,000 | |
| Cell Phone | 1,000 | 1,000 | 1,000 | |
| Travel | 4,000 | 4,000 | 4,000 | |
| One-time Expenses | ||||
| Loss on Sale of Assets | 10,000 | – | – | |
| One-time Bad Debt | 5,000 | – | – | |
| Lease over charged | 15,000 | 15,000 | 15,000 | |
| One-time (Revenue) | – | |||
| Gain on sale of Assets | – | 6,000 | – | |
| Seller’s Discretionary Earnings | $511,718 | $701,718 | $896,218 | |
| Less: Cost to replace owner | (125,000) | (125,000) | (125,000) | |
| Adjusted EBITDA | $386,718 | $576,718 | $771,218 |
This is the correct calculation of Adjusted EBITDA as shown in a Valuation Report by My Biz Value.
The bottom line is for the 5 reasons listed above, ADJUSTED EBITDA is a more important and relevant metric to use as an income multiplier when calculating true cash flow and the value of a medium sized business.
Adjusted EBITDA or EBITDA? Part 2 of 3
Now that we have a good baseline Earnings number we need to look at Interest, Taxes, Depreciation, and Amortization.
Interest Expense. The interest you can add back is all interest from debts and credit cards and consumer debts. It also can include finance charges. What interest does not include is bank fees, charges, or merchant fees. The interest you can add back is all interest that the new business owner would not have if he were paying cash for the business and had zero debt.
Taxes Expense. The taxes you can add back are income the taxes for the company. This add-back only applies to C-corps that you use a baseline number of Earnings After Taxes and not before taxes. If you use Earnings before taxes as a baseline number, then you don’t have to add back taxes for a C-corp. since the tax expense hasn’t been added to the Income Statement.
It doesn’t apply to S-corps or LLC’s or Partnerships. This includes all state and federal income taxes. It does not include payroll taxes, sales taxes, or local taxes. This is the tax your business pays. When you have an S-corp or Partnership the taxes flow through to the owners as individuals.
Depreciation and Amortization Expense. These can be found at the following locations on the tax returns and financials.
- Compiled, Reviewed or Audited Financials – look on the Statement of Cash Flow for the Depreciation and Amortization Expense if it is not shown on the Income Statement, Statement of Revenue and Expenses or Statement of Operations.
- Schedule C – sole proprietor – Line 13 and 27a for Amortization Expense
- Form 1120 – Line 20 or the Statement for Line 26 for Amortization Expense
- Form 1120S – Line 14 or the Statement for Line 20 for Amortization Expense
- Form 1065 – Line 16c or the Statement for Line 20 for Amortization
- Internally Generated P&L – Depreciation and Amortization are usually shown as line items expenses.
One item to note is Section 179 depreciation is not an item you add back.
These are the expenses you add back for a simple calculation of EBITDA. This is place where you start to calculate “Adjusted EBITDA”. In Part 3 of 3 this post I will cover Adjusted EBITDA, how it is defined, and how it is calculated and used.
Adjusted EBITDA or EBITDA? Part 1 of 3
There is a lot of discussion in the M&A world about EBITDA and a wide variety of opinions about what is included and what is not included. Many advisors, sellers, and buyers are using an “adjusted” EBITDA figure for sales transactions. How do EBITDA and “adjusted” EBITDA differ? This is part 1 of a 3-part series about the important metric we call EBITDA.
Calculating EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) may seem like a simple thing to do, but there are many factors that come into play that aren’t part of an over-simplified calculation. These include: owner wages, replacing the owner, perks, excess wages, discretionary expenses, partners and their roles, etc.
Let’s begin with the baseline number: Earnings. Earnings has many titles including: Sales, Gross Profit, Net Income, Taxable Income, etc. It is easy to get confused by these titles and not understand the true meaning of the word as it pertains to EBITDA. In a recent transaction I had a business owner who “swore” his business was worth 1.5x Earnings. He had understood Earnings to mean Gross Sales, not EBITDA. He was using the right multiple with the wrong number for Earnings. Here is a list of where you can find “Earnings’ to use as a baseline for calculating EBITDA:
- Form 1120 S (S-corp). Ordinary Business Income – Line 21
- Form 1065 (LLC/Partnership). Ordinary Business Income – Line 22
- Form 1120 (C-corp). Taxable Income – Line 30
- Net Income from an internally generated P&L
- Schedule C – Net Profit or Loss – Line 31
- Income Before Taxes on an Income Statement. Interest.
Once you have a good starting number you can proceed to Step 2 of calculating EBITDA. This will be covered in Part 2 of this series.
Working Capital: An Important Consideration When Selling A Business
Working Capital is defined simply as Current Assets Less Current Liabilities. Some advisors will include a certain amount of average inventory in Working Capital as well. Some advisors do not include Inventory in the Working Capital. Because of this it is important to define Working Capital as it pertains to each individual deal.
Inventory can be included in the Asking price and can be excluded. A good rule of thumb is for deals over $1 million, a normal amount of inventory is included in the Asking price and not included for smaller deals. Excess inventory (inventory that is escalated due to the seasonality of the business) is usually not included, even for transactions over $1 million. For this reason, it is important to pin down a good average inventory number in the LOI phase of the deal.
Working Capital Target. This is the amount of Working Capital that is required to be sold with the business. Working Capital is a moving target, so it is helpful to set a benchmark amount for closing and adjust the Selling Price up or down accordingly. It is very important to set expectations for this amount at the LOI phase of a deal because expectations about this can differ and cause a deal to unwind unnecessarily.
Working Capital is generally not considered in deals smaller than $1 million in deal size, but it is an important part of deals over $1 million. Working Capital is an important element of a business sales transaction and should be a consideration of every deal. Even small deals will require the Buyer to consider how much Working Capital she or he will need after closing.
What is Fair Market Value anyhow?
When determining the value of a business there are many terms which can be confusing. The term most often used if Fair Market Value and is defined as:
The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
1. The Buyer and Seller are typically willing and knowledgeable.
2. Both parties are well informed or well advised, and each acting in what they consider their own best interests.
3. A reasonable time is allowed for exposure in the open market.
4. Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto.
5. The price represents the normal consideration without special or creative financing or sales concessions to outside parties.
What is missing from EBITDA?
Working Capital
When a business is sold, Working Capital (Cash, Accounts Receivable Inventory, and Accounts Payable) are usually included in the sale for businesses with a value over $1 million and not included for businesses worth less than $1 Million. When it is included, a “normal” amount of Working Capital is included, but the term “normal” varies greatly and is part of the negotiation process. The Working Capital is a measure of cash a business needs to support day-to-day operations, but when evaluating a company for an acquisition, not only is total Working Capital important, the change in working capital before Close should be watched as well. A Working Capital Target should be negotiated at the time a LOI is signed.
Relying solely upon a multiple does not take into consideration additional working capital a buyer will need for the newly acquired business, post-close. Working Capital is an important consideration to make when a business is being bought or sold regardless of the EBITDA multiple used for value.
Real Estate Improvements – Tenant Improvements
A Purchaser of a business generally will assume a location, whether through a lease or a purchase of property. Tenant improvements are often missing from EBITDA multiples, yet he cost of the improvements are often an expense post-close as the acquiring party invests in paint, signage and other improvements to ensure the acquired location matches the Purchasers standards. When evaluating the cost of an acquisition, if tenant improvements are anticipated, they should be included as an expense when calculating EBITDA.
CAPEX
Future CAPEX or capital expenditure needs are not included in the EBITDA of a business. These are the funds a company uses to buy or upgrade the physical assets of the business. If you have a business that has very little fixed assets, it isn’t important, but if you have a business which is capital asset intensive (trucking or manufacturing) the depreciation is a cost that should not all be added back when the company considered is a capital-intensive business. In these cases, EBIT (Earnings Before Interest and Taxes) would be a better multiple to use for these types of businesses.
CAPEX represents depreciable assets, yet, these expenses are removed from EBITDA. The problem with this is CAPEX is a very real cost, and a critical consideration when evaluating a business. Because of this, it is important to include projected CAPEX expenditures post-close when evaluating the entire value of the business.
Conclusion
Multiples are a quick and easy way to evaluate and compare multiple deals across an industry. EBITDA provides a “tried and true” method to calculate true cash flow, but both can be misleading, and, when not fully understood, are prone to manipulation. When an advisor is evaluating the merits of an acquisition, it often pays to devote the extra resources to develop a financial model that takes CAPEX, Tenant Improvements, and Working Capital into consideration.
My Biz Value was founded by a CPA who spends time in the trenches, managing mergers and acquisitions of companies with high growth potential. Rick Krebs, dubbed an “expert sale-side advisor” by Forbes, developed the My Biz Value system because he’s passionate about helping entrepreneurs and business owners achieve successful transactions. He’s also obsessed with timeliness, accuracy and value.
Rick Krebs - Business Broker / M&A Professional 