You can easily Google information on the three basic approaches used to determine the value of a small business. We use the income approach and specifically the “multiple of discretionary earnings method.” What you won’t learn from an Internet search is what it’s really like moving through the process. Candidly, it can be a little bit like having someone go through your underwear drawer.
The reason it may be uncomfortable for a seller is because it is at this early stage in the relationship with their broker that the broker needs to gain a complete understanding of the company’s financials. More often than not, there is generally some hesitation from the seller related to “coming clean” for fear of being judged or worse – reported to the IRS.
Let’s be clear - a broker does not represent the IRS nor is she in any place to judge what personal expenses have been run through the company. The broker simply needs to know what those expenses include. Coming clean early in this process does a number of things: 1.) it builds trust; 2.) it helps maintain credibility with potential buyers and their lenders; 3.) it alleviates leaving money on the table (if personal expenses are omitted); and 4.) it can expedite the due diligence process down the road.
Understand that as the broker is reviewing and verifying add-backs, they are doing it with the buyer’s lending institution in mind. The bank will eventually ask for documentation for these discretionary earnings (DE) expenses and your accountant will be asked to link these expenses on the P&L to the tax return. Taking a pre-emptive approach, a good broker will ask for a “reconciliation of the P&L & tax return” early on to ease the due diligence burden down the road.
Seller, broker, buyer and banker, we’re all in this together. Understanding the bigger picture and knowing what to expect should minimize the surprise and facilitate trust.
You may also want to read: What’s in a Business Valuation?