Valuing a Business: Non-Recurring Expenses
Valuing a business for any reason – particularly in anticipation of bringing it to market – involves significant analysis and dozens of issues to consider. One of those issues is what’s called “non-recurring expenses”.
Non-recurring expenses are those that the business does not incur on an annual basis. For example, capital expenses are generally non-recurring.
“Capital” expenses can cover a wide range of things such as replacing computers, printers, servers, etc. at the end of their life cycle; acquiring a new delivery truck; the costs of expanding or upgrading a business’ space; upgrading a production line; the purchase of new software or retooling for a special project.
When valuing a business, capital expense analysis should not necessarily be part of the process – unless such expenses are anticipated. More on that at the end of this post.
But what I want to focus on here is “one time” or “extraordinary” expenses, an extremely important category to consider when valuing a business. And brokers must know the difference between discretionary expenses and one-time expenses.
“Adjusted” Net Income: What Goes Into the Owner’s Pocket
One-time or extraordinary expenses – I’ll refer to them as one-time expenses from this point forward – are defined as those that the business is extremely unlikely to incur in the future.
Why does this matter?
Because the value of most Main Street and Lower Middle Market businesses is derived from the business’ “adjusted net income” and one-time expenses are presumed to not be repeated. As the business is usually valued based on expected future net income, identifying and re-categorizing non-recurring expenses is important.
Adjusted net income is the result of recasting the financials – the process of determining the actual amount of money the owner of the business can put in his or her pocket.
That process entails examining the business’ expenses to determine which ones, either in whole or in part, are not germane to the operation of the business. Both one-time and capital expenses can fall into this category.
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A simple example of an expense that is not pertinent to the business’ operations is one we use in our course, Learn How to Value and Successfully Sell Businesses.
That example describes how the owner of a transfer warehouse and freight-forwarding company enjoyed some unusual “owner benefits”.
His business leased large freight transfer stations throughout the U. S. and sub-leased portions of those warehouses to major trucking and rail companies. The business’ tenants – UPS, FedEx, and most of the major freight lines – might lease a dozen slots in the building. They bring freight in on one side, break it down inside and load it on to out-bound trailers on the other side. This enables the freight lines to pick up freight in many regions and bring it to a central transfer warehouse for sorting into truck-loads of products destined for particular areas.
For example, trucks from all over Michigan, Indiana, Ohio and Kentucky, each loaded with freight destined for delivery to a dozens of locations, pull in to the inbound side of the transfer station where the freight is unloaded, then sorted so that everything headed for Kansas City is loaded on one truck on the outbound side of the transfer station; everything headed for New York into another outbound trailer and so on for other geographic areas.
But it turned out that the owner of this business had a fondness for classic cars and one of the warehouses his business leased was in the dry environment of Nevada and was used to store those cars.
Because the business broker knew what he was doing, he asked the right questions and discovered the existence of that warehouse and, because it had no relation to the company’s operation whatsoever, the cost of that warehouse was then subtracted from the expense numbers, thus increasing the actual net. This expense was an “owner benefit“.
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That example was one of finding and adjusting for “discretionary” expenses which is our objective when we recast a business’ financials. But it is NOT an example of a “one-time” or extraordinary expense. After all, it was an expense that the company incurred every year though it was certainly not an operational expense incurred in the running of the business.
One-Time and Extraordinary Expenses
When valuing a business, an example of a one-time expense would be environmental remediation.
We recently meet with the owner of a large truck and tractor maintenance and repair business. One of the first questions we asked was related to potential environmental hazards. The owner acknowledged that, when he took over the business from his father 25 years ago, he knew that there had been fluid leaks from vehicles and drums. We advised that he get an environmental survey done to determine the extent of any damage.
The expense of the survey is a one-time expense. If the survey turns up a problem – which is likely – the owner would be wise to mitigate that problem. The cost of that mitigation is another one-time expense.
But if the environmental authorities had discovered the problem before we were called, there would have been an additional one-time expense in the guise of the significant fine that would be levied.
And if that fine was of such magnitude that the business had to set up a payment plan that spread the fine payments over several years, that “one-time” expense would appear in the business’ financial statements for several years in a row.
You’ve got to ask the right questions.
Another example of a one-time or extraordinary address would be tax penalties which we find to be fairly common.
If a business is late in the filing of its taxes, it is likely to suffer penalties for such behavior. We’ve dealt with businesses the financials of which included tax penalties year after year. But even though they were incurred consistently, we would certainly characterize these as “extraordinary” expenses that would not necessarily be incurred if there was better cash-flow management.
“Anticipated” Capital Expenses
One final note.
Early in this post I mentioned that capital expenses should not become part of the valuation process – unless they are anticipated. By that I mean that if the business owner has chosen to forego required maintenance or upgrades, the cost of such maintenance or upgrades will be borne by a buyer almost immediately upon closing the acquisition – and those anticipated costs must be factored into the valuation.
An example from our files comes from a healthcare client. Thirty-seven computer workstations, two servers, specialized software and various other elements of their IT network were beyond their lifecycle. In fact, the operating system software was so dated that it was no longer supported by the manufacturer.
Much of the network was no longer in compliance with healthcare regulations and the entire network had to be replaced or upgraded – to the tune of about US$85,000. This anticipated cost had to be factored into our valuation.
The Bottom Line
When valuing a business, ferreting out one-time and extraordinary expenses requires asking questions about every line item of a business’ financial statements. If the business broker doesn’t do that, you can be sure that any qualified buyer will.
If the business is valued – and then priced – before calculating for such expenses, it’s likely that the value determined is wrong and that the price asked doesn’t reflect value; all of which suggests that serious buyers will walk when THEY discover the problem.
If you have any questions or comments on this topic – or any topic related to business – I’d like 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 safe and profitable week.