I’ve noticed a recurring theme across many business owners that is seriously dampening the value of their companies – that is, running personal expenses through the company. Perhaps unknowingly, they are doing just that – giving up $2 to save 30 cents.
Certain types of personal expenses are expected and easily added back (health insurance, life insurance, disability, charitable contributions, personal cell phone, some personal use of car, some travel (e.g., for corporate board meetings with minutes), etc.) – but they share two common traits: (1) they are easily identified, verified, and documented and (2) they generally comprise less than 25% of the total seller’s discretionary earnings. Other types of personal expenses are not easily added back and directly reduce the value of the company (without even delving into the tax law/accounting questions). These include a myriad of expenses, such as groceries, excess personal meals, unverifiable/undocumented travel, household expenses, sporting equipment, etc.
Here’s the math: assume a 30% marginal tax rate (on both income and the sale of the business, although this is probably a little high for the sale of the business as much of it will be at capital gains rates). For illustration, also assume that buyers are willing to pay for a company an amount equal to $2.85 for every $1 of Seller Discretionary Earnings (smaller, less profitable/lower margin, stagnant revenue, or less desirable locations/operations will be less). For every dollar of personal expense that an owner runs through their company, they are saving 30 cents in taxes. However, when they go to sell their companies, every $1 of expenses that can’t be added back reduces their income and seller’s discretionary earnings by a $1, reducing the purchase price by $2.85. Assuming a 30% tax rate on the sale (which is probably high), they are giving up after-tax proceeds of $2. So in one year, they are giving up $2 to get 30 cents. Almost a 7:1 negative trade. To prevent this, let’s say they kept the personal stuff out of their books for 3 years (which would be ideal), they would be gaining $2 by giving up 90 cents in cumulative tax savings – a 2.2:1 trade, not a bad return in anyone’s eyes.