Source: Todd Ganos from Forbes
Selling a company? In our first installment of this series on the value of your business, we noted that your company can have multiple values at the same time depending on who the potential buyers are. In the second episode, we identified that you need to assess where your company’s financial performance stands relative to other companies in your industry and of your size. We also identified that only the top 20% are being bought for USDA Prime prices. In our last segment, we talked about how you are keeping those financial records — if they are not in GAAP format, expect a meaningfully lower price. Starting with this installment, we will get into what you might do to enhance the value of your firm when it comes time to sell.
The first two things we need to look at relate back to accounting.
Are you doing anything to intentionally skew your numbers? Yeah, intentionally. We’ll put the question into perspective. Cash flow is the real deal. Earnings are easily manipulated. In a publicly traded company, one might see a divergence between cash flow and earnings. Experience point to earnings being substantially higher in these companies. What’s the deal? Executives are typically compensated via stock options. Stock prices typically react to earnings — as opposed to cash flow. So, there is a monetary incentive for executives to adopt accounting policies — within the GAAP framework and that will survive audit — that will juice up earnings.
In a privately held company — such as yours — one might see a divergence between cash flow and earnings . . . in the opposite direction. Experience points to earnings being substantially lower in these companies. What’s the deal? Lower earnings lead to lower income tax. These owners have a monetary incentive — lower taxes — to adopt accounting policies — within the GAAP framework and that will survive audit — that will depress earnings.
In a publicly traded company, executives will adopt accounting policies that capitalize items that are properly expensed. The classic example was in the 1990s. Everyone in the known universe received at least two dozen CDs from America Online to promote its service. Rather than expense the cost under marketing, AOL labeled it as customer acquisition costs and capitalized them over the average customer tenure (which was seven years). Another example that is a little more subtle is failing to write-down outdated inventory. Stuff that’s just never going to sell. No write-off, no hit to earnings.
In a privately held company — such as yours — let’s say it has inventory. Irrespective of what a physical count might yield — and putting proper write-downs to the side — the dollar value for that inventory might be reported as a little low compared to what is really is. That lower dollar number translates to higher cost of goods sold, which translates to lower earnings, which translates to lower income taxes. Nothing about your operating cash flow changes. But, your tax burden is lower.
Here’s the problem for you: for tax reasons, you’re doing all you can to create lower earnings and those lower earnings work against the sale price of your company. Ugh.
The second question asks whether you’re doing anything that unintentionally skews your numbers. This one might be a little more tangible but is not something you really think as skewing your number . . .and you say “Oh, I didn’t realize.”
So, let’s say that you have your product line or your service line. And, things are working fine. But, you say to yourself that you need to stay ahead of the competition. Or, you’d simply like to deliver a better product or service. So, you invest. There are those capital investments. But, while those are important, we’re talking about the investment called “research and development.” That money will be expensed and will be a hit to earnings.
Here we have to make an important distinction. There are companies that have ongoing R&D outlays — that never stop. We’re not particularly concerned with a skew. They are what they are. But, there are companies that have “one off” R&D outlays. These expenses are not normally in the financials over time and they appear in only one or two years. Over time, they look like a pig going through a snake. How might these unintentionally skew your numbers? An adjustment must be made.
So, the last article in this series spoke to the need to have GAAP financial statements. This article is saying that even with GAAP-compliant financials, there is a range of things that can skew your numbers . . . some intentional and some unintentional. Hopefully, you’re getting a deeper sense of the issues in play.
In our next installment of this series, we will get into managerial choices that can affect the value of your company.