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Be Careful with Discretionary Expenses

Posted by David Humphrey on 8 December 2014 | Comments

What’s in it for me? From GE and HP to the local entrepreneur. Every buyer of every business asks: If I buy this business, take it over and run it well, what is in it for me?  While there are often many answers to this question depending on the individual business, one area of chief concern among all businesses is profitability. For many closely held businesses certain expenses, which are discretionary or unnecessary, even if totally legal, can obscure true profitability.

A few examples:

A business owner regularly attends the industry trade conferences, which just happens to be in Maui in February.  While this conference is probably interesting, for most owners it is the lure of Maui, not information, which is the primary reason for attendance.   

Some owners hire their children to perform a function in the business and overpay them for this service.  The extra expense may be a way to save taxes, a form of estate planning or just a generous parent helping out a child.  Salaries in excess of what the owner would pay a nonfamily member, or if they would even hire a person at all, is typically considered discretionary. 

Lastly there is the appeal of an automobile provided by the corporation, for which the board generously approved the German luxury model as necessary for the image of the corporation’s executives.

In the years leading up to sale, owners should work to limit their business expenses to those that are truly operationally necessary and will likely continue post acquisition.  Many business owners feel when the time comes, they can go through each discretionary item with the buyer and explain them.  Some buyers will listen and agree, some will listen and not care basing their decisions on financial statement data, and still others may simply move on to the next opportunity.  Further, lenders will likely not listen at all and will base their decisions on the financial statements and tax returns provided, creating a gap between price expectations and available cash at the closing.