Negotiations on my business sale were several weeks along when my buyer started to ask disturbing questions. They’d compared my business account’s net income figures with the monthly profit-and-loss (P&L) statements for the monthly-membership platform I’d spent a decade building.
Weirdly, net revenue in the business account was lower than the P&Ls showed. A lot lower.
As we dug into the numbers, it became clear that the accountants I hired to help me prep the business for sale were incompetent. They misclassified some expenses and double-counted some revenue. The result was that my business was revalued to a lower sale price.
I thought I’d done everything right, hiring accounting pros to do P&Ls. Instead, I was going to have to accept $100,000 less than expected for my business, if I could even get the deal done. I spent a solid week feeling like I was about to throw up. Clearly, there was more I should have done to clean up my books before marketing my business for sale.
How can other first-time sellers avoid the mistakes I made? To find out, I talked to an experienced business broker and two accountants with expertise in business-sale finances. I’ve compiled the 12-point checklist below based on their advice.
1. Get accounting software
Are you tracking your business expenses and revenue in a spreadsheet? It’s time to get serious and start using a pro software package.
“You want to make sure you have accounting software in place,” said Lauren Colson, CPA and founder at Colson Strategies, an accounting firm that helps companies prepare their books for sale. “It’s going to give you more credibility as far as accuracy.”
2. Hire the right accounting professional
When you’re contemplating selling your business, not just any accountant is right for the job (as I found out to my great disappointment). You want experienced accounting pros who regularly work with business owners to prep their books for sale. Ideally, it’s an accounting group with multiple CPAs rather than a solo practitioner.
If you’ve made accounting a low priority in your business up until now, their first task is to clean up the past three years’ records, says Holly Magister, CPA, certified financial planner, and founder of the seller’s resource and advisory platform Exit Promise LP. Buyers will often want to research back that far.
“Make sure there are very clear, clean records regarding the income your business has,” she said. “Because buyers purchase based on revenue and the profit it produces.”
3. Consider accrual instead of cash accounting
Once you’ve got pro software and accountants, look at your accounting method. Many small businesses operate on a cash basis because it’s simple to administer. But if you sell annual memberships or create service contracts the business fulfills long-term, the cash method doesn’t create the most accurate income picture, said Daniel Chamberlain, who’s a senior M&A associate at the tech-business advisory firm FE International.
For instance, if your business runs a Black Friday sale and offers 40% off your annual plan, your revenue trend will show a big spike and then a big drop-off with cash accounting, because you booked an unusual number of annual plans in one month. With accrual, those annual plan fees are divided among the 12 months the plan covers, giving your business a less volatile income line.
“Buyers want to know how it’s impacting monthly income trends,” Chamberlain said. “Accrual smoothes out the revenue.”
4. Put all income and expenses on the books
Sometimes, small business owners have two sets of books: one for the IRS, and one that records additional off-book income they’ve kept from tax agencies’ eyes. That may have saved you on taxes over the years, but hidden income is a major liability when it’s time to sell your business.
Buyers will read your tax forms to confirm what you’ve been taking home from the business, said FE’s Chamberlain. If some of the business income is missing, the company seems less successful and your valuation will be lower. Also, having to reveal to buyers that you’ve been skirting your tax responsibilities makes them wonder what else you might be hiding.
The solution for this accounting mess is painful but worth it, says Magister of Exit Promise. Come clean to the IRS, re-file corrected returns, and pay the taxes and late penalties you owe. The amount you pay will likely be dwarfed by the added value the additional income will generate in your sale, since most businesses sell for a multiple of income.
“There should be no ‘wink-wink,’ off-the-books recordkeeping,” Magister said.
Hidden expenses are another problem. If your business has switched lenders or credit cards over time, be sure expenses from obsolete loans or cards get recorded, noted Chamberlain. You don’t want a buyer asking why half a year’s web-hosting charges seem missing, which you then realize were paid from a previous account.
“You’re trying to build rapport with the buyer,” he said. “As soon as one thing is missing, even by accident, it makes them think: ‘What else is missing?’”
5. Keep different books for each business
Often, entrepreneurs have more than one business going – and there’s a lack of clarity about what income and expenses belong to which business, said FE’s Chamberlain. All the businesses may be lumped together in a single set of P&Ls, with their assets listed on the same balance sheet.
“It makes things extremely difficult in a sale,” he said. “It’s hard to convince a buyer that all these expenses don’t relate to the business you’re buying.”
If you’ve commingled revenue and expenses between businesses, have your accounting team tease them apart. You need a discrete set of P&Ls that reflect income and expenses only for the business that’s up for sale.
Can’t fix the mess? Another approach is to sign an attestation confirming revenue and expenses for this particular business, Chamberlain said. This legal document holds you liable if it’s discovered in future that you weren’t honest about which income and expenses were part of the business you sold.
6. Create monthly P&L statements
Monthly profit-and-loss statements are the first thing experienced buyers will ask for – so be ready with yours. If you’ve got pro accounting software in place, generating monthly P&Ls should be as easy as pushing a button.
Three years’ P&Ls would be ideal, but at least make sure you have 12 months of crystal-clear, accurate P&Ls, says Magister. As you go through the marketing process and new months close, your accountant should keep adding fresh monthly P&Ls.
As an added bonus, having clear P&Ls is a strong tool for making good business decisions on your way to a sale.
7. Reconcile accounts
Once you have accounting software, check to ensure you’ve accurately recorded all your transactions. If you’re working with an accounting team, they should do this for you.
Do this by reconciling bank and credit card statements with the entries in your accounting program, said Colson. The totals across your business accounts should match the total your accounting software shows.
“Even when you link the accounts to your software, things can happen,” Colson said. “Maybe you accidentally deleted something. Balancing proves this is actually the revenue you received.”
8. Streamline and correct expense classifications
Colson noted that the more simple and straightforward you can make your accounting, the easier it is for buyers to understand your business’s financial story. Buyers like to see simple expense categories.
For instance, sales taxes are commonly misclassified as income, Colson said. In fact, it’s a pass-through money you collect but must remit to the appropriate government agencies. Card-processing fees are another item that’s often erroneously included in revenue.
Another way to simplify is to boil down expense categories.
“You don’t need to break out ‘meals I ate in my car’ from ‘meals I ate in a restaurant,’” Colson pointed out. Let the IRS’s basic business expense categories be your guide.
9. Improve accounts receivable
Does your business have a stack of unpaid invoices from slow-paying customers? Getting old invoices paid can boost income. You also don’t want to leave a lot of outstanding invoices hanging in a business sale, Colson said, because it may reduce your buyer’s offer.
“Maybe some of that A/R comes off your valuation,” said Colson, “because the buyer isn’t sure they’ll be able to collect on it.”
10. Maximize seller’s discretionary earnings (SDE)
Now that you have your books in better shape, you have financial information you can use to improve your business’s attractiveness to would-be buyers. One key metric buyers look at is seller’s discretionary earnings. SDE is essentially net income with any personal expenses you’ve had the business pay added back in.
Too many add-backs can make a buyer feel like you’ve been using the business as a personal piggybank rather than taking profitability seriously. See if there are personal expenses you could cut now to create a cleaner SDE statement.
Magister said, “If you’re paying your mother-in-law to work and she doesn’t even live in the state where you do business, get rid of it.”
11. Pay off debts
If you have many small loans with different financial institutions, or outstanding balances on several business credit cards, it’s time to consolidate debt. Better yet, pay it off if you can. Buyers aren’t excited to take on a business with many different debt payments coming due monthly, and debt service eats into net income, noted Magister.
Also review any assets you’ve been depreciating. Magister said she found 30-year-old assets that were fully depreciated long ago still listed in one company’s books.
“You want to simplify your debt structure on the balance sheet,” she said.
12. Do some tax planning
Once you start the sale process, you’ll be busy marketing and then negotiating your sale.
Now that you have nice, clean books and a clear understanding of your business’s valuation and likely sale price, have your accountant explain the tax consequences of the possible coming windfall, or better yet, work with a financial planner who can help you both minimize taxes and figure out what you’ll do with the money when it comes in. Then you’ll be ready to negotiate a deal that lets you keep more of the proceeds.