Last week we have seen how Sultan and Jen made both the same mistake of misjudging Add-backs into their business valuation, ending up in Sultan selling out cheap and Jen struggling to find a buyer.
We have covered how the standard formula for Net Income is given by Yearly Sales minus Operation Expenses and minus Cost of Goods Sold. We mentioned that such number alone could be misleading. In fact, some costs included in or excluded from the Operation Expenses could be only applicable to the current management.
For example, Sultan is an avid fitness enthusiast, and every day takes 2 to 3 hours to practice his favourite sports.
To enjoy this liberty, he needed to hire someone to replace him at work during his absence.
And since he had someone to back him up, he used to stretch his break all the way up to 5 hours a day including commuting and meals.
Sultan lost more than 100 hours of productivity a year. Yet, he did not factor that in when pricing his business. Not only he was paying an extra employee that the new owner does not need, but he also did not fully capitalise on his product knowledge and expertise to boost sales.
So to make Sultan’s valuation more accurate, he should have subtracted his extra costs and his loss of income. I did a rough calculation on his behalf: he was paying RO 750 for his staff to replace him, and I simulated a 15 per cent loss of income due to his absence.
All together it summed up to nearly RO 20 thousand a year! Sultan applied a x3 multiplier when he valuated his business, meaning that he took his yearly Net Income and multiplied it by 3. Before doing so, he should have added back the add-backs at RO 20,000 times 3 years, for a total of RO 60,000 higher valuation.
Jen’s case is the opposite. She runs her business seven days a week with her sister, and neither of the two pay themselves a monthly salary.
They just use the business’ cash to pay for their expenses, which is greatly discouraged for proper accounting.
Moreover, they live together with their parents, so they do not pay any rent. In a nutshell, Jen’s Operation Expenses are extremely low.
Too low for anyone else that could buy her business, unless she finds someone who is also willing to work 7 days a week with no formal salary.
In her case the Add-backs should be estimated on normal conditions, with one day off a week (reduced income) and at least one and a half salaries to be paid.
By omitting these Add-backs, she is over valuating her Net Income, and since she is also applying a x4 multiplier, nobody seems to be interested in taking over her company.
Add-backs are not the key factors in valuating a business, but given their nature, in case of a sub-optimal management they might represent a drastic shift in the final valuation.
My recommendation is to engage skilled accountants that are able to segment costs based on their category. Some costs could indeed be part of the Operation Expenses, but the ability to separate Add-backs could represent a substantial difference in the final business valuation.
[The columnist is a member of the International Press Association]
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