After our first meeting and before reviewing his financial statements, I concluded that this is a viable business, it has good customer lists, niche product with steady suppliers, dedicated employees and the owner has created a good systems for its employees that allows him to continue to grow the business and work "on" the business. However, the seller had developed some health issues and needs to exit from the business.
I suggested the seller provide me with the financial statements in order for me to determine the most probable selling price for the business before we head to market. I was told that I will receive it in a few weeks since the year just ended and the accountant is completing the financials. But the owner provided me with the breakdown of the revenue, costs of goods sold, labor costs and general expenses of the business in order for me to have an understanding of how the financials are made up. The numbers made sense and it all looked good until......when I actually received the financials.
The income statement showed revenues of less than 30% of what I was told and the costs of labor was significantly lower. So I decided to meet with the seller to find out why the numbers look so different.
That is when I was told that the some of the sales are paid in CASH and therefore are not recorded, and for the cost of labor, the employees are only paid for 37.5 hours a week although they work approximately 45 to 50 hours a week. The balance of the wages are paid in cash.
This scenario occurs more common than one might think in many small businesses across the country. One of the common reasons for business owners not recording their income is to avoid paying taxes. However most business owner do not realize that when it comes to selling a business, having a higher net income and paying taxes, increases your chances of selling the business and for a much higher price.
Let's do a simple scenario on two similar businesses operating in Alberta.
Company A did not record all of its revenue and only chose to record revenues of $500,000 and had a net income before taxes of $100,000. Assuming a corporate tax rate of 25%, this company would have then paid taxes of approximately $25,000.
Company B on the other hand recorded all of its revenue of say $600,000 and let's assume that it had a net income before taxes of $150,000 Again assuming a tax rate of 25%, Company B would have paid taxes of $37,500.
Now let's see how the value of this business differs between Company A and Company B.
Let's say that businesses in this Company's industry sells for 2.5x's of net income before taxes. So Company A is valued at $250,000 ($100,000 x 2.5) and Company B is valued at $375,000 ($150,000 x 2.5) or a difference of $125,000.
If you now factor in the taxes that was paid by the owners of the two companies, Company A paid $25,000 in taxes and Company B paid $37,500. So the taxes saved by Company A for not recording its full gross revenue is ONLY $12,500, while it could forsake over $125,000 ($375,000 - $250,000) when it goes to sell the business due to it recording methods.
In addition, business owners often do not realize the risk of revealing their "CASH" income to strangers who inquire about their business. My recommendation when it comes to cash income is to report it, especially 3-4 years before the owner plan to sell his/her business.