The following article is based upon a number of situations. Names, locations and other facts have been changed to illustrate and simplify. Any resulting similarity to any one business or person is coincidental.
“Normalization” and “blue sky” are two business sale concepts that get seller’s attention real quick because both can increase the price of a business significantly. Normalization is separating owner’s discretionary expenses from regular, reoccurring expenses to calculate “real” income and “blue sky” is all about potential. Unfortunately for sellers, even if the buyer agrees to higher values based on these concepts, there are limits on both.
Businesses typically sell on a multiple of yearly earnings after subtracting expenses. But are all expenses the same? Sure, a paper expense is a paper expense but what about the travel and entertainment expenses that weren’t absolutely necessary? Sellers wonder, “Shouldn’t those be backed out because the buyer wouldn’t incur them unless they wanted?”
Selling owners often run wild, claiming discretionary expenses apply to items such as cell phone expense of the owners; magazine subscription expenses; training expenses; as well as the expense of the Porsche delivery truck. And each time an expense is eliminated, the calculated earnings go up and the value of the business goes up as it is a multiple of earnings. Great for the seller, eh?
Here’s the problem. Even if you and the buyer agree these expenses can be excluded resulting in more income and a higher selling price, the two of you don’t make the rules. Who does? The banker who is loaning money to the buyer to buy the business makes the rules.
And they are known to challenge every normalized expense as they go by the simple rule that if you tell Uncle Sam it’s an expense; then they believe it's an expense.
What’s allowable? The list varies but most commonly extraordinary expenses include storm or flood damage to the shop in a specific year. Depreciation and amortization is typically removed as it’s a non-cash expenditure as well as interest (see my article or other information on EBITDA method of valuation). And usually ONE salary of an owner is excluded.
Some not-so-allowable "normalizations” are the Porsche delivery truck; travel and entertainment; cell phones; and training expenses to mention a few.
So how do you know what’s allowable and what’s not? You don’t; not always. So, if you are within the three- to five-year range of selling, stop expensing discretionary items and clean up your income statement. Yes, it will increase your income and you will pay more in income taxes. However, you will receive more value for the business. You’ll have to do your own calculation to figure out which is more valuable to you.
Telling a buyer that you earn $50K of cash that’s not reported does nothing but tell the buyer you are dishonest, which kills most deals because it destroys trust.
Think about it. If the seller would lie to the Internal Revenue Service, which has the ability to put them in jail, what chance do I have in getting the truth? Don’t do it.
Kansas Banking Commissioner Joseph Norman Dolley, railing against deceitful investments in 1910, observed that certain “fraudulent investments were backed by nothing but the blue skies of Kansas.” The term stuck in financial circles. For our purposes there is a fine line between potential and “blue sky.”
Potential is possible as opposed to actual. It’s something that could be there but it’s not there yet.
A local economy that is doubling in size every five years shows potential and a business located there would be valued higher than the same business in a shrinking market.
If you tell me I have to increase sales and I’ll make a ton of money; well, that’s “blue sky” because it is something I have to do. I’m not paying you for what I have to do.
It’s great that your business has plenty of potential for earnings and growth. That will definitely influence a buyer in whether or not to buy. It may even tend to drive up the price as more prospects will be interested. But don’t confuse “potential” with “blue sky.” And don’t confuse the process of “normalization” with recreating history. And for gosh sake, don’t tell me you lied to the Internal Revenue Service. There are limits, after all.
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