Most owners of small to medium size businesses (SMB) use every legal trick in the book to avoid paying a penny more federal and state tax than they absolutely must. You probably know that one of the biggest advantages of owning a small business is having the opportunity to use the business to minimize your personal income tax liabilities.
The process of making adjustments to the financial statements of a SMB is called Normalizing or Recasting. Normalizing or Recasting means working between the lines (i.e., between revenue to net income) to add back to profitability all of the charges to expenses that weren’t absolutely necessary or were of a “personal expense” nature. The purpose of this important exercise is to clearly identify the dollars that were a benefit to the seller and would be available to the buyer had they owned the company during that period.
The foundations of value, especially in the market for SMBs is Seller’s Discretionary Earnings (SDE) or Earnings Before Interest Taxes, Depreciation & Amortization (EBITDA). Calculating these is a bit tricky, so it’s advisable to obtain the services of a professional experienced in valuations. The approach is to consider not just the net income, but all the cash benefit flowing through to the owner.
There may be debate between the parties as to whether or not the buyer would proceed in the same way but there should never be debate about the expenses or items that were of benefit to the owner. The more SDE / EBITDA a business is generating, the more it tends to be worth, although the relationship is not a linear one.
“Rules of Thumb” (ROT) are sometimes used by professionals to determine the value range of a business. These ROT can be dangerous if not used in conjunction with proper valuation methods such as the income and market approaches. ROT can vary wildly between industries and change over time as market conditions change. Businesses that are within the same industry should be assessed on desirability, risk and terms which will affect the proper ROT.
