Picture a magic slot machine. Each time you pull the arm, you make back a multiple of whatever you wagered. How much time would you devote to cranking that arm?
When it comes to the value of your business, you can make many bets, but only one has a virtually guaranteed return. Most companies are valued on a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA), so every dollar of incremental profit you earn in the short term will translate into a multiple of that down the road.
Since most acquirers look at three years’ worth of financial reporting, squeezing out every extra dollar of profit makes even more sense if you’re considering an ownership transition in the next thirty-six months.
How Derek Morin Jacked Up the Value of His Business
For an example of a founder obsessed with finding every dollar of profit available, let’s look at Derek Morin. Morin founded Tabarnapp to create after-market sales applications for Shopify website owners.
The business was a success, but when his partner, who handled finance, left the company, Morin was forced to look closely at his profit & loss (P&L) statement. Morin saw potential improvements, so he made notes in the margin next to each line item he wanted to change.
To save time, he started using a single letter beside each entry to represent the action he wanted to take:
- P stood for “Plus,” something profitable and something he wanted more of.
- U stood for “Unnecessary,” an expense he could eliminate.
- R stood for “Replaceable,” a cost that could be replaced with a better or cheaper option.
- E stood for “Equal” and was used for items that should be left untouched.
Morin realized his shorthand notes could be organized into a memorable acronym he referred to as “PURE.”
Morin treated the PURE method like a game. Every month, he scrutinized his P&L with the same four-letter system. Morin engaged his team to act on each item that needed improvement. He became obsessed with squeezing out a few more dollars of profit every month.
His game worked. In 2020, Morin bought out his business partner in a deal that valued the company at around $400,000. Two years later, after applying the PURE methodology of improving profitability, Morin sold Tabarnapp in an agreement that implied a roughly tenfold increase in the value of his business.
The Downside of Using Your Company’s Bank Account as a Slush Fund
There’s a downside to treating your company like your piggy bank. Comingling personal and business expenses while letting other costs go unchecked may help you reduce taxes in the short term but could end up costing you more in lost value when you decide to sell your business. Instead, keep your P&L “PURE” to jack up the value of your business.
Incorrectly Minimizing Expenses Can Impact Your Business’s Value
One mistake a small business may make is to focus too much on ways to increase their taxable expenses. They do so to minimize the business’s tax burden. Of course, legitimate deductions are a necessary and helpful part of any business, but some companies take deductions too far. This is mostly done by privately held, family-owned, or closely held businesses.
Some of the ways they may attempt to minimize tax liability are by putting relatives on the payroll even though they don’t technically work there. They may pay family members a minimum amount of money per year so that they can enroll them in a health insurance program.
Other businesses may give themselves perks like season baseball tickets. Yet they only use the tickets for business entertainment occasionally. Most of the time, it’s used for family outings. They may use family cars as a deduction or purchase items that aren’t for the business.
In other words, businesses may use anything they can to increase deductions, lower profits, and minimize their tax burden. A publicly traded business would handle things differently, maximizing earnings and reducing expenses. They do so because it increases the company’s valuation.
That doesn’t mean you won’t have any personal or discretionary expenses to run through the business. Shareholders can still use expenses to minimize their tax burden if they are determined to do it, but they need to ensure that it’s done legitimately.
With a close analysis of business expenses, preferably by a business advisor, you can use deductions legitimately and still get maximum value from your business and increased cash flow. One solution is to simply take a distribution for the expenses you’re taking as a deduction. Then pay for the items yourself. Doing this minimizes expenses, allows you to purchase those extras, and keeps the company’s worth elevated.
Consider How Actions Can Affect a Sale
Even if you’re not planning to sell your company right now, it’s crucial to keep that consideration in the back of your mind. Some day you may want to sell. If so, are you maintaining an efficiently run, profitable business? Remember, when someone buys your business, the expenses you may be claiming right now will be eliminated. The buyer understands this and will look at the big picture when deciding what price to pay for the business. If the company value is deflated due to erroneous expenses, it won’t bring in as much money. The buyer looks at what the company’s “normalized earnings” are as if you operated as a division of a publicly traded company. The higher your earnings are, the higher your valuation will be upon an exit.
Seek Business Consultancy
A financial consultant can provide the advice necessary to help you balance the expense reporting with maintaining the valuation of the business.
At Twelve Points Business Advisors, we offer a comprehensive look at your business. With our years of expertise, we can help you maximize business valuation and put you in a stronger selling position.