Do Small Business Seller's Add Backs Make Sense? - Three Tests
When putting a small business on the market for sale
, the owner often has to explain that he or she has been reducing taxable profits by charging the business for products and services not really needed to operate effectively.If the restaurant, manufacturing firm, retail store or service company is paying for the owner's vehicle expenses and life insurance premiums, it will show reduced, taxable earnings. Meanwhile, the owner is reaping the benefits of those costs.
But when the business is offered for sale and the objective is to show the most amount of profit, the seller may "restate" the profit and loss figures, adding back those payments made by the business but not necessary for its successful operation. When examining a P&L that has been restated in this way, a buyer will notice that some business expenses have been added back to earnings. This practice can be abused, however, with the risk to the buyer that some of those add- backs are actually necessary operating costs. Three common-sense ideas can help when evaluating add-backs so buyers can determine if they are legitimate.
1. A buyer is advised to question the seller of the small business about the add backs, to make sure they are legitimate. Don't just take his or her word for it. Vehicle expense may be a legitimate add-back if the car is merely driven to work and back home. But if deliveries are made, and supplies picked up using the vehicle, the buyer needs to know that. Under those circumstances, any suggestion that vehicle expenses ought to be added back is really a misrepresentation. The buyer who believes the statement is in for an unpleasant surprise.
2. While there may be some expenses charged to the business that aren't necessary for successful operation, it's possible that a portion of the costs in a category are needed to conduct business. Is all of the company's travel and entertainment expense used by the owner for fun with family and friends? A buyer should learn what percentage of those expenses are actually required for taking prospective clients to lunch and attending important trade shows.
3. Buyers of small businesses should remember that a seller who, for tax purposes, is "stretching the truth" about what are legitimate business expenses, may apply the same standards of honesty when making representations about the business. And what should be carefully considered is just how much the seller is willing to exaggerate. It isn't unusual for an owner conducting business in the company vehicle to run a personal errand and neglect to reimburse the company for the precise cost related to that part of the trip. An argument can be made that this is a minor disregard for the rules, the seller more trustworthy, compared, for example, to the liquor store owner who claimed he'd remodeled the business premises, when all $60,000 spent for construction actually went into his home.
Yes it's nice to discover that a small business being considered for purchase is earning more than the stated bottom line once personal expenses are added back. Buyers are advised, however, to verify that the expenses are legitimate add backs, not necessary costs of running the business.
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