Entrepreneurs face the question of what their company is worth, namely when they sell the company. Business owners naturally attach higher values to their company than do potential buyers with widely divergent values leading to the failure of a company handover.
To avoid such failure, we recommend addressing the issue of corporate value when you first consider a succession plan, which should be at least five years before the desired date for retirement. This lead time allows for several alternatives for the company handover, which alone contributes to an increase in value.
If you are considering the idea of selling your company, then we recommend you check these value-driving factors and take appropriate action.
Related: Value Creation: Risk Management.
Financial Data: Focus on the Last 3 Years
Financial data from the three years before the anticipated sale of the company forms the basis for the company’s valuation. As part of the sales process, these figures are often subject to strict due diligence by accountants and other advisory persons.
Candid, detailed financials avoid mistakes that lead to a too low sales price or liability risks and legal disputes after the sale. Insufficient information may conceal risks or give the appearance of subterfuge.
As a rule, the purchasing party reviews the target company’s financial figures for the past three years and factors that information in determining the company’s value or price. Those 3-year financials are then projected three to seven years into the future to calculate an expectation for future earnings and expenses.
Other methods, such as the standard multiplier method or the tax-influenced simplified income value method, use the last three years’ financials to confirm a trend.
Separate the Company from Private Life
Private motives often shape the accounting of a non-capital, market-oriented company to minimize taxes by shifting expenses to the operational sphere. For most entrepreneurs, the first conversation about a planned company sale is held with a tax advisor. That’s a good thing.
One should be aware of the income tax consequences and possibly inheritance tax options. Often, the tax advisor also looks after the bookkeeping and the annual financial statements, business reports, etc., created. The tax advisor’s actions focus on keeping the entrepreneur’s tax burden as low as legally possible.
However, the tax advisor must change perspective when selling, as minimizing the company’s tax profile leads to a lower company valuation that does not show the true power of the company.
In practice, tax structures are often seen as a gray area, for example:
- Fixed assets (cars, furniture, equipment, etc.) are declared operationally but used privately.
- Tax breaks are realized from the employment of family members or family members who are not paid market rates compared to unrelated persons.
- Excessive rental payments for a privately owned business property or building.
- Consultancy contracts for existing shareholders or other related parties.
- Hospitality expenses for private meals.
This list goes on.
Disentangle purely tax-motivated options in the first year! Carefully check where you may have such tax-minimizing constructs and think about tax audit risks. These will often be part of a guarantee catalog as part of the sale, for which you usually continue to bear the risk. Always be aware of the tax structure and the future economic picture.
Every improvement in results ultimately leads to an increase in the company’s value.
Account for the Entrepreneur’s Wages and Risks
The unbundling of private and business can also go in the other direction, especially when things are not going well for the company. In such circumstances, the entrepreneur and family members may work without pay. In this case, the buyer bears the risk of an overvalued company.
More frequently, however, risks are disregarded or insufficiently taken into account in the books. Undetected, such risks incur considerable liability. If they are discovered during due diligence, that discovery can derail the entire sale.
Accounting Best Practices
To exclude possible price-reducing factors and to convey a good impression overall, you should have your accounting under control. Even so, a careful auditor may find the following common accounting mistakes:
- Accounts receivable has considerable old stock or inventory that can no longer be legally claimed and for which no value adjustment has been made. Make yourself aware of the valuation, especially in the case of obsolete inventory, and use the following inventory for necessary value adjustments.
- Your book of accounts contains assets that are no longer in use. Dispose of such assets by removing their costs and the accumulated depreciation from asset accounts. Also, account for profit or loss from their sale, if any.
Due diligence–i.e., a check of financials before the sale–can detect and resolve financial discrepancies. We strongly recommend choosing an independent and impartial auditor who was not involved in the company’s bookkeeping.
Do a Risk Inventory
Risks that are only discovered during due diligence serve as the buyer’s starting point to reduce the purchase price. Risks uncovered after the sale can lead to high recourse claims within the framework of the guarantees given by the seller. This is very understandable because a potential buyer does not want to acquire a pig in a poke.
The most common mistake in annual financial statements under commercial law and taxation is the failure to consider risks in the form of provisions. Provisions are liabilities of uncertain amount or reason. These can include product liability risks, ongoing legal disputes, soil contamination, dismantling obligations for rented premises, etc. It behooves both buyer and seller to become aware of these risks in the context of a risk inventory and evaluate them according to the probability of occurrence and utilization.
Bring the Company into Shape
Everyone knows first impressions are crucial. This truism also applies to a company sale. Potential buyers often get their first accurate impression of the company when they tour the property. Buildings in disrepair or outdated products in the warehouse can significantly reduce the perception of value. This becomes noticeable during price negotiations.
Help your company make an excellent first impression by:
- Thoroughly cleaning production space
- Executing necessary renovations
- Updating staff spaces, e.g., painting the walls, purchasing new furniture
- Complying with legal requirements
- Selling obsolete goods and superfluous equipment.
Ensure a long rental period. Reduce the risk of a possible change of location by ensuring that your successor can rent the premises for as long as possible. For this purpose, renegotiate with the landlord if necessary.
Revise IT infrastructure. A modern and comprehensive IT system geared towards the company’s needs usually imparts massive, long-term cost savings. Compare the company’s needs with the available solutions before selling and consider an upgrade in part or whole. This can significantly increase the company’s appeal to the buyer.
Continue investing in the company. Many company owners put the brakes on investing in the company after they decide to sell it, so everything remains at the status quo. If, after two years, there is genuine interest from a buyer, the lack of continued investment in the company can lead to a noticeable decrease in its value. Therefore, continue working toward and investing in the company’s optimization.
Dedicate the three years before selling the company to corporate optimization. These three years of growth form the basis for the company’s valuation and are subject to due diligence. Clean up bookkeeping and perform a risk inventory. For support, consult external auditors who have not been involved in the company’s accounting, are impartial, and have a clear view of the goal.