Valuations: Extraordinary Expenses
Over the past several weeks I’ve written several posts about valuing businesses. One was about defending your numbers. If you’re a broker doing valuations, you are guaranteed to encounter sellers with whom you’ll need to do just that. Another was about dealing with a stubborn seller and when simply defending your numbers isn’t good enough; you need to ask the Ultimate Question. And last week was about determining what the owner’s benefits are – which helps to determine the real bottom line. The real earning capacity of the business. This week I focus on extraordinary expenses.
Extraordinary expenses are usually one-time expenses. For example, a small manufacturer might need to upgrade its manufacturing software to stay competitive.
Let’s say that the owners of a manufacturer of widgets doing $5 million in sales realize that the software governing an important aspect of their manufacturing operation is outdated and the software vendor is phasing out support. As the owners have attended industry trade shows over the past couple of years, they’ve noticed that their vendor – and similar companies – have been hawking software upgrades that make manufacturing operations more efficient – and they know that their industry is moving in this direction. Their vendor has visited them and shown that the new software would have a significant impact on their bottom line within 12 months.
The owners decide that a software upgrade is the wisest move and they invest $100,000 to make it happen.
As I write this – late October, 2018 – U.S. tax regulations (IRC Section 179) allow for 100% of such an investment to be expensed in the year it is incurred. A business broker analyzing the financial statements of this business will see this expense and, if the broker knows what he or she is doing, will question the business’ owners about the details. Upon learning what this expense entails, the broker will know that this is an “extraordinary” or “one-time” expense; one that is not recurring and, therefore, will not be incurred in the future. As such, to determine the true earning capacity of the business, an adjustment will be made in the expense column because the business will not incur this expense in future years.
Our client owns a professional practice and has been expanding its revenue and client base handsomely over the past several years. The trend is continuing this year and additional staff was hired necessitating additional fixturing, cabinetry and other improvements that will cost about $45,000 but that would be expected to last many years. The acquisition costs of these items will show up on the client’s financial statements and 2018 tax return as an expense.
A knowledgeable business broker, examining and graphing three to five years worth of financial statements and tax returns will note this unusual expanse and ask about it. Learning what it was for, the broker will adjust the expense totals for the same reason explained above: this $45,000 expense is a “one time” or “extraordinary” expense that will not be incurred in future years.
The Bottom Line
This exercise is part of the process of recasting a business’ earning, a critical step in determining the value of a business and one that I’ve written about often in this blog and discussed in various podcasts. The objection is to determine the “discretionary earnings” of a business; essentially determining its earning capacity for the near future. Adjusting the expense totals as described herein will provide a buyer with a much more accurate estimate of the business’ earning capacity – what a buyer is interested in and will pay for – and, in both these examples, will provide a much more accurate measure of the value of the business.
This process generally will also help the business’ owners to understand how the market of buyers is likely to value their business – and it will strengthen the broker’s arguments when defending his or her numbers.
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The world needs more qualified business brokers – professionals that understand how to analyze a business’ financials and separate the extraordinary expenses (as well as other non-operational or unnecessary expenses) from the true operational expenses. If you’d like to become such a professional, let me know in the box above.
As I mentioned last week, if you’re a professional business broker, share this and the past couple of posts with your clients – whether they are business owners thinking of selling or buyers looking for the right business at the right price. Doing so should impress them with the knowledge that you know what you’re doing.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!
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