Hockey Sticks Don’t Score Goals in Business Valuations

As you consider transitioning your business—whether through a sale, passing it down to family, or structuring an ESOP for employees—it's crucial to begin with a clear understanding of your company's real value. Many business owners, perhaps including you, have historically minimized reported earnings to reduce tax burdens. While this approach has its benefits, it complicates the valuation process when you're ready to sell.

Like many business owners, you've likely managed your financial statements to show minimal profit, aligning with strategic tax planning advised by accountants. This practice, while common and legal, results in a low net operating income on your tax returns.

When you engage a Legacy Business Transition Advisor, MA advisor, or business broker, they should introduce you to a process called 'normalization.' This process adjusts your financials to reflect the true profitability of your business. Normalization involves adding back discretionary expenses such as an owner's salary, any perks given to non-working family members, and non-cash expenses like depreciation and interest.

However, some business owners demonstrate their financial attractiveness in the short term as they approach a sale, leading to a sudden spike in profitability. For example, the business might be showing business owner profit of around $250,000 year after year and then suddenly just prior to go in the market this is shows $500,000 in profit. This is often referred to as a 'hockey stick' in earnings. While this may reflect positively as increased free cash flow, it raises red flags for prospective buyers and financiers, who may suspect manipulation and be hesitant to proceed without a sustained track record of higher earnings.

Buyers, particularly those relying on external financing, will scrutinize these financials. Lenders and investment groups are wary of recent spikes in profitability and typically require a demonstration of consistent, higher earnings over multiple years before they commit funds.

If you find yourself in this situation, you might consider delaying the sale of your business to demonstrate a sustained level of higher earnings. Alternatively, revising past tax returns to reflect higher earnings might be an option, though this can lead to higher tax liabilities and complexities—always consult with your accountant or attorney before making such decisions.

In some scenarios, buyers may offer to purchase your business for a certain price now, with the promise of additional compensation if the business continues to perform well over subsequent years; this is often referred to as an Earn-Out. This can align incentives but requires careful contractual arrangements.

These topics are complex and vary significantly by business. If you're navigating these waters, consider reaching out for a free consultation on business valuations and ownership transitions. Understanding the full scope of your options and the implications of each can provide peace of mind and strategic advantage as you plan your business’s next chapter.

Thank you for your time, and we look forward to assisting you. Whether you’re looking for a business valuation in Florida or anywhere around the United States, we’re here to serve. Legacy venture group helps people sell a business, value, business and exit of business. Please reach out for your FREE CONSULTATION.