When you sell a business, you want to learn what the true profits of the company have been. Even though a business for sale may show very little profits, it could be very profitable. I have seen companies showing low profits but in fact the operating companies earned $3 million in normalized profit. They had other assets in the company which were not being sold and that business was generating losses which were being used to offset against the profits of the main operating company.
You may have tried to minimize tax to by putting non reoccurring expenses in the business. This can include salaries of family members who are not working in the business, entertainment expenses, personal expenses, travel etc. You may have put all these expenses in the company but will an investor believe you and agree that all these costs are personal and should be added back to net income to determine normalized profit. What is good for tax minimization is not good for the sale of the business. The more adjustments there are for normalized earnings, the more questions that they investor will have. I knew a company who was in a very loose buying group. Each member of the buying group was a competitor and each resided in a different country. If one person created a product which sold well in his home country, he would offer it for sale to the other members at a predetermined profit level. This allowed the originator to get a better price because he could then buy in larger quantities than he could sell in his native country. It worked for everyone. Each year, the people in the buying group would have a convention and they would get together for a few days. One day was business, the other was entertainment. When the owner decided to sell the business, he described the travel costs to be personal and not business. He would also go on holidays, see a few clients so he could write off his trip and then called the entire trip personal. Would a buyer of the business consider this personal? If the buyer was paying a multiple of earnings and if he agreed that this was personal, then the purchase price would go up say 3 times this amount if he offered an earnings multiple of 3x normalized earnings.
If you are using the cash flow of the business and have huge shareholder loans, you are not expensing all your personal expenses however you owe the company money. The company is now borrowing from its lines of credit to support your life style. Do you add back the interest costs associated with financing the personal loans?
Many people believe that you add back the owners salary to normalized income to get a higher price for the business. If the owner was active in the business, he is entitled to a salary because you would have to replace them with another person after they left. The real question is how much would you have to pay a third party to do the work that the owner does. Part of the owners compensation may be because he is an employee, partly as the owner. If the owner was paid a salary of $250,000 but you could replace him with a person earning $100,000, then $150,000 would be added back to normalized earnings. Sometimes it is not that clear what you have to pay. The seller of the business will say you can replace me for $20,000, the investor will say $100,000. Which is right? You can put down any number you want as a seller of a business, the buyer of the business will have a number in mind and if you cannot come together on the number, then you will not sell the business to him.
You can ask any price you want for the business but in the end, you will get the fair market value, not more, not less. You may be happy that you got a certain price and that the buyer in your opinion paid more than he should have, but in actual fact, you do not know what the buyer has in mind and he was willing to pay that price so he is happy he bought it for a fair price. Some people will think that they buyer of the business got a steal for buying the business but that is because the owner had an unrealistic opinion of the value of the business in the first place.