Many business owners don’t spend a lot of time working on the major financials of their business until it’s time to sell. But you should really be managing them long before a deal would ever come into play. Interested buyers or investors will be asking a lot of questions about your financials, and you want to have answers that show you’re managing things well.
The accounting method switch you can’t delay
If your business operates according to cash-basis accounting, you’re not exactly alone, but you’ve got a bit of a problem that you need to address before you do almost anything else. Cash-basis accounting essentially counts revenue when it appears and expenses when they’re paid. It is easy, it’s fine for running the business, and it doesn’t mean much to a prospective buyer.
Institutional buyers and private equity groups demand accrual-basis accounting, where revenue and expenses are synchronized to the period in which they are earned or become due. That’s the only way revenue and expense recognition conform with generally accepted accounting principles and can be compared uniformly across different business entities. A buyer may not know if your earnings are steady or if you’ve been managing the timing of receipts and disbursements to goose results in certain periods without it.
The swap to accrual accounting – hopefully in adherence with GAAP – needs to occur at least a year to two years before you are ready to set your business on the market. Buyers want to see a history, not a recent transition that could be concealing inconsistencies. The sooner you start on accrual accounting, the more dependable the record of your recent business performance will be.
How business expenses are scrutinized during due diligence
This is the spot where sellers turn into deer in the headlights more than anywhere else. Literally, everything in the expenses section of your financials is going to be pulled over by the buyer’s team, and they’re hunting for two types of prey. First, they want to find any costs that aren’t legitimately part of the business and therefore shouldn’t be charged against it in their calculation of the company’s EBITDA. Second, they want to find any costs that are real and should be included in that calculation, but you’ve pared back in recent years to goose the EBITDA as part of your exit planning.
The first group of those costs are your add-backs. These are real, non-recurring, or non-essential business costs that the buyer agrees not to hold against the company in the EBITDA calculation used in the final sale price. Typical add-backs include owner comp in excess of what a market general manager would cost, personal autos, club dues, one-time legal expenses associated with a lawsuit last year that won’t be paid again, or rent significantly above the comparable rate for a building that is owned by property owners who are also the family that owns the business.
You don’t want to be developing your add-back list and digging up substantiating records on them in response to an inquiry from a potential buyer’s accountants. You want to have a clean, well-documented add-back schedule ready to roll, with records to back every single one. No record equals no or reduced credit for the add-back. Record in hand equals yes, and every ‘yes’ puts cash in your pocket.
SDE is what most small businesses are actually valued on, and here buyers focus less on the income statement and more on the balance sheet and add-backs. Most owner-operated businesses have plenty of discretionary expenses or benefits. What actually gets added back on top of COGS, OPEX, Depreciation, and owner’s salary is often very reflective of the buyer’s day to day lifestyle and other expenses so it is quickly defensible. For those other items that don’t necessarily tie to benefits to the owner that is where they dig to confirm for themselves the expenses exist and should be added back.
The second category is more dangerous. Some owners cut business expenses in the year or two before a sale – reducing marketing spend, deferring equipment maintenance, letting key roles go unfilled – to make EBITDA look higher. Buyers will find this. They’ll compare your capital expenditures over time, look at whether spending patterns changed dramatically in recent years, and call it what it is: under-investment or deferred maintenance. When they do, they’ll either reduce the price or demand an escrow holdback to cover the deferred costs. Don’t trade a short-term EBITDA bump for a discount that’s three to five times that number at close.
Teaming up with a niche local firm, like the best CPA in Queens, NY, means your cleanup will be tailored to the specific nuances and rules of your territories. This is invaluable wherever you operate, and absolutely critical if any of your potentially acquirable competitors are based in the same geography.
Cleaning up the balance sheet before anyone looks at it
Buyers don’t buy your P&L alone. They buy your balance sheet too. And if it’s a mess, they’re not paying you for it. Three particularly important steps to take well before the sale:
- Write down or write off obsolete inventory. A buyer isn’t going to give you credit for a stockpile sitting in your warehouse that hasn’t moved in two years – they’ll just see it as a headache they’ll have to pay to remove and dispose of. Not worth their time.
2. Identify and write off uncollectible accounts receivable. A buyer is going to dig into your aging schedule, and you don’t want your largest receivable to be from a customer who went out of business 18 months ago. If it is, they’ll begin to wonder just how conservatively you are accounting for everything else.
3. Resolve or establish and document the amounts of outstanding liabilities, particularly any that are disputed or informal. These are major red flags that slow down due diligence and give buyers opportunities to make reductions in the price.
Internal controls: the infrastructure of financial credibility
An often-overlooked step in getting financially ready is establishing your internal controls. Those are the systems, processes, and checks that can prove (or disprove) that your numbers are correct and haven’t been messed with.
The conceptual basis is segregation of duties. If the person who approves vendor payments also reconciles the bank account and posts to the general ledger, that’s a control gap. Buyers, particularly ones backed by institutional capital, will suss this out. Most aren’t assuming fraud. They want to know how reliable those three to five years of historical financials are likely to be. If the controls weren’t there, what would stop a business owner from getting too aggressive or making an error on their taxes?
Good internal controls don’t demand a big accounting department. They require lots of paperwork, a structure for oversight, proof that those checks happened, and a lot of honesty. It’s easier to build this reputation over time than to try to retrofit trustworthiness into several years’ records on short notice.
Managing the working capital peg
Most sellers never think too much about working capital until they’re well into the process and all of a sudden, there’s a problem and you’re $100,000 apart on what your cash equivalents are supposed to be left in the business at closing.
The working capital peg is the target level of working capital – accounts receivable, inventory, minus accounts payable – that the seller is required to deliver at close. The number is usually based on a trailing average. If you’ve been running high working capital and the peg is set accordingly, you’ll be expected to deliver that level at close. If you start aggressively collecting receivables and extending payables to pull cash out of the business before close, the buyer will see a working capital shortfall and adjust the price accordingly.
The right approach is the opposite. In the months leading up to a sale, accelerate collections on your accounts receivable. Bring that aging schedule down. Manage payables deliberately rather than stretching them beyond normal terms. A clean, predictable working capital position strengthens your negotiating stance on the peg and reduces the risk of a closing adjustment that cuts into your proceeds.
Tax exposure analysis: find the problems before buyers do
Uncovered tax liabilities during due diligence represent one of the top two reasons business sales fail. Pepperdine reports that 31 percent of both failed and repriced selling efforts occur because of subpar financial records and/or uncovering of unexpected tax exposures by a buyer. Uncovered taxes are often a buyer’s best negotiation tool, reducing either the buyer’s risk through escrows and earn outs (none of which benefit the seller) or the price.
Our most common experience is cities and states applying sales tax based on economic nexus, not registered nexus – your sales and activities in their market, not just your physical presence there. Similarly, sales and payroll tax compliance issues commonly arise when operations cross into adjacent jurisdictions without proper withholding and filing. If your business sells products or services in states where you have economic nexus but haven’t been collecting and remitting sales taxes, that’s a liability. Buyers will find it, estimate the exposure, and either indemnify for it or reduce the price.
Do a pre-sale tax exposure analysis. Identify every jurisdiction where you might have nexus, review your historical filings, and address the gaps. Some exposures can be resolved through voluntary disclosure programs. Others can be quantified and disclosed proactively, which is always better than having a buyer’s team discover them and run their own numbers.
The sell-side Quality of Earnings report
A Quality of Earnings report is often regarded with trepidation by founders and business owners. It sounds a bit like putting your company through an IRS audit when in fact, it’s an incredibly valuable tool for getting the best deal when you sell your business. It’s all about ensuring that there are no surprises when a potential buyer starts poking around in your financials.
Most QofE reports are conducted by the buyer, but a growing number of sellers are flipping that process. They’re commissioning a Quality of Earnings report before they go to market, giving them a chance to spot and address any issues before they’re used as leverage to make price adjustments.
A sell-side QofE also signals sophistication to buyers. It shortens due diligence timelines, reduces friction, and builds confidence in your numbers. For mid-sized businesses, the cost of commissioning one is a fraction of what a single price adjustment during negotiation might cost you.
The real work happens before the first offer
Preparing your business for sale doesn’t consist in preparing a good set of books for the occasion. It’s in the preparation of making your business’ financials accurate, defensible, and clean enough to pass the level of due diligence that serious buyers will be doing. Owners who make these preparations beforehand – switch to accrual accounting, normalize add-backs, resolve tax exposure, establish internal controls, etc. – enter the negotiations from a position of strength. Owners who don’t, spend the back half of due diligence reducing their own purchase price.
