Recasting Financials to Maximize Business Value

Oilfield Industry Newsletter, September 2014

A Tale of Two Lamborghinis

“On your P&L we noticed a $484,000 one-time expense charged to your American Express account in December. Did you guys buy a couple of trucks on your Amex card to get the air miles?” This was one of a number of drill-down questions Fred and I asked the two business owners as we were preparing a valuation report of their very successful business. Hesitantly, they responded, almost embarrassed – “We bought two Lamborghinis, and yes, we did get the air miles, which we used for a family vacation to Europe.”

Though the pair of Lamborghinis was a bit extraordinary, the motive behind the purchase is a common theme for business owners – to minimize taxes. Business owners enjoy the freedom to manage financial transactions in a manner that suits their personal interests. In many cases these transactions are recorded to minimize the reported net income of the business, which in turn minimizes income taxes to the owner. When preparing a business for sale, a different approach must be taken – to recast the company financials “as if” it was operated to report maximum earnings.

In the oilfield industry, where valuation multiples have become rich again, we invest a lot of time and energy preparing Valuation Reports for business owners before we agree to represent them through the sale of their company. Valuing a business starts with a detailed review of the company’s historical financials and recasting (adjusting) their financials to establish “Adjusted EBITDA”. Adjusted EBITDA significantly improves the earnings of the business by identifying and adding back expenses including excess owner compensation, owner perquisites, equipment and vehicle purchases, family & community expenses, and any non-recurring expenses.

Here are some common EBITDA adjustments we come across in oilfield businesses:

  • Major repairs and improvements expensed as cash that a large corporation would capitalize and depreciate. These include saltwater disposal well work overs, engine replacement, chassis remounts, etc.
  • Family expenses that would be non-recurring to a buyer. These include payroll and benefits for family members not active in the business, vehicles, cell phones, travel, and entertainment.
  • Owner perquisites and hobby expenses. This is a wide category based on personal interests, however in the oilfield some common examples include rare firearms, hunting and fishing trips, boats, planes, luxury vehicles, race cars, motorcycles, and home improvements.
  • Rent expense paid to a sister entity in excess of fair market value.
  • Charitable donations and community support. Most common – the National Rifle Association.

The time and energy we spend recasting company financials is crucial to unlocking maximum transaction value for our clients. Buyers will accept the recast adjustments we prepare for our clients because they are credible and defendable. Since buyers base their purchase price based on a multiple of Adjusted EBITDA, it is important to account for every dollar adjustment because of the magnifying effect it has on the final purchase price of the business. In today’s rich valuation market, 7 times EBITDA in certain circumstances is not unheard of. In this situation, every $1 added back to EBITDA results in a $7 increase in purchase price. Adding back the $40,000 F-150 your son drives to school (paid for, insured, and fueled through the business) increases the value of the business by almost $300,000. Ultimately, it is the responsibility of the seller (and their representatives) to report Adjusted EBITDA to a buyer.

What did we do with the pair of Lamborghinis our client bought? We adjusted them out of the financials and properly supported the adjustment as “owner perquisites”. This resulted in a purchase price increase of nearly $3 million.

Maximizing transaction value begins with the recasting of financials to determine a company’s real earnings “as if” they were owned by a buyer, taking into account the tax minimization and other discretionary expenses that reduce corporate earnings. Understanding buyer appetites and running a competitive auction process adds additional value to the process of a business sale. At Shotgun Capital, we take pride in our ability to maximize the transaction value of our clients every step of the way.

If you’re interested in learning more about our views on the industry or have questions about what your business may be worth, feel free to give us a call anytime at 817.421.5940. Our motto is “no pressure, no B.S.”, and all conversations are held in strict confidence.