Recasting Financial Statements – Vital To Your Business’ Valuation

By Generational Equity

09/26/2012

OK, so you have made the biggest decision of your professional life: You have decided that it is time to find a buyer for your business. For years you assumed that your children would carry on the legacy of the firm, but they have clearly told you that 80-hour workweeks along with all the risk inherent in running a family business do not interest them.

Your fallback was to then sell the company to your employees and retire on the future earn-out that the deal would provide. But after taking a long hard look, you realized that as skilled as your employees are, the downside financial risks for you are too great to “hope” that they could run the business as well as you have and provide for your retirement in the process.

So the optimal option, as you have determined, is to find a buyer who can grow and expand your legacy while also providing you with the capital you need for retirement.

The question now becomes: What to do next? The answer is to hire an experienced M&A advisory firm that can perform a thorough and complete evaluation on your company. This is vital before entering the market.

Of course you can do this on your own if you are well versed in the practice of “recasting.” If you have not heard of this term, or if you are not sure what it entails, I highly recommend hiring a professional firm do this for you.

Recasting is the accepted accounting principle of removing or adjusting items on your financial statements that are unrelated to the ongoing business. You have probably worked hard over the years with your accountants to under-report your earnings for tax purposes. This is perfectly legal and acceptable. But it understates the true value of your company.

Keep in mind one key principle of the selling process: Professional buyers are buying your future, not your past. The only way to accurately highlight your future profitability is by recasting your historical financials and then projecting out three to five years using the new recast baseline as your starting point.

Items removed or adjusted via recasting can be superfluous, excessive, or discretionary expenses and nonrecurring revenues and expenses. The recasting process can be quite time-consuming and tedious. The person providing the service will ask you lots of questions and will dig deeply into your historical financials to find as many legitimate recastable items as possible.

Again, buyers are buying your future and will base their offers on what they see in your financials. So if they are not recast accurately, your base year could understate your profitability, impacting what buyers will pay for your company.

Case Study: For example, let’s assume a buyer is looking at two similar companies in the same industry. Both are generating similar levels of revenue.

• Company A is showing $500,000 in EBITDA (earnings before interest, taxes, depreciation and amortization) on its latest fiscal year income statement.
• Company B, again doing the same level of revenue, was wise enough to have its financials recast, and it is showing EBITDA of $750,000.

Which of these companies do you think will receive a better offer? Assuming that there are no extraneous issues affecting Company B, it will most likely generate better offers than Company A. With this example, you can see how vital recasting is in protecting you from offers that are too low.

Caveat: Our discussion of recasting presumes your financials are in good order and follow GAAP (Generally Accepted Accounting Principles). If not, you need to start there and get your financials cleaned up as we discussed earlier this week. If not, no matter how carefully you document your recasting, your actions could be based on inaccurate financial information.

The Art and Science of Valuations

As I mentioned earlier, it is possible to produce an evaluation of your firm on your own. If you have an accountant that is experienced with recasting (many are not) and if you have the time to spend not only analyzing your business but also objectively documenting your growth opportunities, you could produce your own evaluation document.

However, having done the recasting, the question now becomes: How do you determine the value of your company? This is where it becomes critical to have the services of an experienced M&A advisory firm.

You may be aware of standard “multiples” for your industry, and sometimes these can be quite accurate. But again, professional buyers are buying the future. This means that they will project your recast earnings into the future and then will “discount” them back into today’s dollars using a discount rate that matches their internal rate of return for comparable investments like yours. The “discount rate” is based on a variety of factors including risk, stability of the investment, believability of the projected revenue growth, etc. This is where it really gets complicated.

Ultimately, a number of methods need to be analyzed to accurately value your company. In addition to the discounted cash flow analysis, other methods that can be used are industry comparables, rule of thumb multiples, asset-based valuations, preceding transactions, etc.

Each method has its strengths and can be used alone or in conjunction with other methods depending on your business. Unfortunately, time and space do not allow me to delve deeply into all of the valuation methods used. Suffice to say, this topic could be several future articles alone.

Knowledge Is Key

The bottom line is this: The valuation of your company sets the benchmark for where you will expect offers. If it is not done accurately, you could be undervaluing your company, placing your expectations too low. Conversely, you could also over-value your firm and end up with expectations that are way too high.

These are things you can avoid if you obtain the services of an experienced M&A advisory firm at the outset of this process. Be sure to contact firms that will not only value your firm but will also stand behind their valuation and represent you in the market. This really is key. Lots of firms will value you, but if they are unable to represent you in the market, how legitimate is that valuation?

Once you have developed a “buyer ready” business and have decided to sell, make sure that the valuation is done accurately. Don’t skimp on this step and try to save money by hiring a firm with less experience. The old adage is true: You get what you pay for.

Generational Equity has been valuing and selling businesses for years. Our team of financial analysts and evaluation managers is second to none in our industry in terms of experience and skill. Their abilities are matched by our deal-making teams that have proven over the years that they can effectively close deals. Feel free to contact us if you are interested in talking about your company and its valuation options.

No matter who you ultimately use to value your company, be sure to work closely with them during the process and ensure that every possible recast is identified and documented. In the end, when the deal closes and you achieve your financial dreams, all the hard work during the evaluation phase will have been worth it.

Carl Doerksen is the Director of Corporate Development at Generational Equity.

Updated June 2021
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