Pay Now or Pay (More) Later: The Danger of ‘Bad Books’
Recently I have consulted with clients who have been considering buying businesses with bad books. For the purpose of this blog post, I will define bad books as financial statements (or the lack thereof) that do not reflect the true value of a business. These bad books create problems for the buyer and seller alike, so let’s look at the reasons for and repercussions of not having accurate financial statements.
Reasons for bad books
Sometimes, the owner has good intentions to keep accurate records, but he/she gets overwhelmed. According to Michael Gerber in The E-Myth Revisited, there are three roles of a business owner:
- Technician – the person who makes the widget and/or provides the service
- Manager – the person who manages the business using available tools and systems
- Entrepreneur – the person who looks for opportunities and threats for the business as a whole
In a small business, the owner has to balance his/her time between the three roles. Many times, the business owner gets so busy in the Technician role that he/she doesn’t have time to tend to the other owner roles, including the bookkeeping. It is not for lack of desire, but more often for lack of time, that the books are not kept in an accurate manner. Because the business owner hasn’t made accurate accounting a priority and put systems in place (Manager role), the accounting suffers. Because the business vitals are unknown, decision-making is often made in the dark and performance can suffer. Besides bad decision-making, there are other consequences, which I will discuss later in this post.
In an effort to pay as little taxes as possible, business owners will often go out of their way to show as little profit as possible. Whether that is through illegal measures such as not declaring all the revenue in a cash-based business or more gray area practices of aggressively writing off barely-business expenses, the net effect is to make the profit disappear.
The problem with showing no profit
When a business owner goes to a bank to discuss financing (for more working capital, more inventory, more staffing or a new parking lot), the banker will immediately ask for profit and loss statements, usually for the last 2-3 years. Gone are the days when deals could be done on a handshake or based on your (or your father’s or grandmother’s) name and reputation. Federal guidelines, as well as local bank policies, make the evaluation and approval process much more rigorous (asking for SBA backing adds another level of scrutiny). Simply put, banks want accurate and positive profit and loss statements, reflecting the ability of the business to service the proposed new debt. If the numbers can’t support the new debt, the loan won’t be approved. Even if the bank allows the owner to explain where the money went (add-backs), it often casts a negative light on the business and/or the owner that can’t be undone.
Selling your business
When it is time to exit the business, the owner will hopefully try to sell the business. In an overly simplified calculation (ignoring company debt, payables and receivables, among other things), the business is worth the assets + the cash flow + the good will (often also called blue sky or something similar). The assets are fairly self-explanatory. The good will is impossible to quantify, so banks will usually not value good will or loan against it. So, that leaves the cash flow.
Depending on the industry, there is often a standard multiple (of cash flow) allowable for a business, from 1x (one times cash flow) to 3-5x (or even more). Regardless of the multiple, having a healthy profit number to multiply by is desirable. If your profit is $0, even 3 or 5 times your profit is still $0. At that point, your business is an asset sale, even if you don’t see it that way. Unless you can find a buyer who doesn’t need traditional bank financing and is willing to overlook the financials, you may have a difficult time selling your business.
The moral of the story
The simple moral of the story is to do the right thing. Record your information accurately and take every legitimate deduction. Pay your taxes and be proud of having a profitable business. Plan and prepare for a future when you will want to get financing, grow your business and move toward an exit event, when you will get paid a fair amount for your business. Sleep better knowing that you aren’t going to get audited or in trouble.
As one potential business buyer told a restaurant owner who chronically under-reported his cash sales – “You have already gotten the benefit from cooking your books. I won’t be paying you again for it.”
The ISBDC can help you . . .
- Assess the state of your current financials and determine next steps
- Find appropriate accounting/bookkeeping solutions and resources
- Plan for the future, including financing and exit strategy