Recasting Company Financials – The Critical First Step of an Optimal Exit

By Generational Group


Before selling your car, you would probably do some research to find out what models like yours are selling for these days. The same if you were selling your home – you might keep a note of what your neighbors received when they sold, or hire a real estate agent to pull all the “comps” on houses similar to yours to give you an idea of potential value.

This is a sensible approach. Yet, you’d be surprised how many entrepreneurs do not take the same approach when it comes to their biggest asset – their business.

Hundreds of companies are sold every year without professional advice. And every year hundreds of buyers rub their hands with glee at the amount they have saved from owners who entered the M&A process without a clear idea of what their business was worth.

I’ve heard enough horror stories of sellers who took the first (and only) offer for their company, leaving millions on the table, to fill a novel. But all of this disappointment and wishful thinking can be avoided through a professional evaluation – with recasting at the heart of this.

What is recasting?

If you work with a good Certified Public Accountant (CPA), then every year they have worked to save you a significant amount in taxes and done this legally. There is absolutely nothing wrong with this – they have lawfully applied ways to suppress your profits to help ensure you pay as little income tax as possible.

However, this has a knock-on effect when it’s time to exit your company. All of those efforts made to minimize your earnings are now understating the true profitability of your company to prospective buyers. Simply put, your company’s financials don’t give a fair reflection of your company’s historic earnings and ultimately, its value.

Of course, when you’re trying to exit for a premium value, this is a major issue. However, it is an issue that can be rectified through recasting.

Recasting, also known as financial statement adjusting, is an accepted GAAP process that eliminates from the historical financial presentation any items that are unrelated to the ongoing business, such as superfluous, excessive, or discretionary expenses, and nonrecurring revenues and expenses.

Fundamentally, recasting offers a picture of your company as though you were dedicated to maximizing profitability. By removing or adjusting items on your financial statements that don’t apply to ongoing business operations, to show the true profitability of your business.

What do I mean by items unrelated to your ongoing business? Anything from owner’s perks and non-essential salaries, through to bonuses, travel costs and rent can be recast to create a more accurate reflection of your company’s finances.

For example, there are many aspects of EBITDA (or EBITDAC as has become more prevalent since the COVID-19 outbreak) that can be recast:

  • If you annually rent a country house for your company retreat (especially if the retreat is really a vacation for you and your family), this is an expense that most likely will not be continued under new ownership, so can be added back to your income statement
  • Your salary and bonuses as owner most likely are above what new ownership will pay for a V.P. or G.M. to assume your role, so a fair market salary should be adjusted on the books historically and going forward
  • If you incurred any one-time expenses, such as a marketing campaign or legal dispute, these won’t be ongoing costs a buyer would take on
  • Fires, floods, theft, and vandalism are other examples of one-time expenses that can be removed since they are not ongoing; and potentially, the loss of revenue and income due to the impact of the COVID-19 on your business as well
  • If you pay more than fair market rates on certain areas of the business, such as the rent for your building because it is personally owned by one of your partners, these can and should be normalized to correct market values
  • If you have non-active relatives on the payroll, these should be adjusted off and other perks like company cars, cell phones for family members and other items should also be adjusted off your financials

This is just a small sample of the areas you should analyze and recast to establish the true value of your business. But it is essential that this is applied across your organization, as it can make a substantial difference to your Business Enterprise Value (BEV). Consider the following example:

Company A did not hire an M&A advisor and therefore has not recast their earnings, and their base year EBITDA is $350,000. This has led their five-year pro forma projections to look like this:

Year 1 = $400,000

Year 2 = $450,000

Year 3 = $500,000

Year 4 = $550,000

Year 5 = $600,000

So, without recasting their earnings, Company A is expecting to generate $2.5 million in earnings in five years. Not bad, but what would happen if they were to recast $100,000 of non-recurring expenses? Their base year EBITDA increases to $450,000, and their five-year pro forma looks like this:

Year 1 = $500,000

Year 2 = $550,000

Year 3 = $600,000

Year 4 = $650,000

Year 5 = $700,000

Company A’s earning projections leap from $2.5 million to $3 million, making it a much more attractive proposition to potential buyers, and more likely to secure a greater value than prior to recasting. Remember, buyers are buying your future earnings so starting from an accurate base year is vital.

Why failing to recast is a major misstep

As this example illustrates, by not recasting your financials prior to putting your business on the market, you could leave millions on the table when it comes time to shake hands with the eventual buyer (while they try to conceal the smirk on their face knowing they’ve picked up a bargain!).

I have a long history of working with experienced buyers, so trust me when I say that savvy buyers will take your historic financials and will “recast” them without you knowing it. They will then offer you an amount for your company based on your non-recast financials which, in most cases, will radically undervalue your business.

Because, above all else, buyers are looking for bargains as much as sellers are looking for premium offers. Recasting is all about giving you a strong understanding of what your company is truly worth before you even begin to entertain offers.

I mean, if you don’t know your company’s potential value, how can you even consider putting it up for sale? How would you know you’re not seriously undervaluing your company, or are setting its value so high that no credible buyer is going to give you the time of day?

Moreover, how can you figure out what steps to take that could increase its value in the eyes of certain buyers?

Recasting as the foundation of value enhancement

When our dedicated and award-winning valuation team at Generational Group recasts and evaluates our clients’ businesses, that is just the first part. Our focus then shifts to offering recommendations of how to build on this initial valuation.

Remember – there’s no such thing as the perfect company. Even if you’re profitable and growing, you may still have underlying issues or factors that give buyers pause for thought. Our team is incredibly skilled in identifying these and bringing them to our clients’ attention – even if it’s not always something they want to hear…

At the conclusion of a professional evaluation, your business enterprise value (BEV) will provide you with an estimated range of what you would receive if you sold your company in the current market. That might suit you down to the ground. But, if it doesn’t, you at least know your starting point, and what you can do to improve on this.

This could be introducing tactics and strategies to grow your revenue, while simultaneously not doing so by sacrificing your profit margins (which is a big red flag to buyers). Or this could be in how your company builds on and presents your intangible assets to particular prospects – their perceived value often varies greatly from buyer to buyer.

Our consulting team (Generational Consulting Group – GCG) has been highly successful over the years in helping business owners build much more valuable businesses than they thought possible.

That’s why arranging an evaluation far in advance of when you intend to exit means that you have time to apply these enhancements. Then, when the market is looking favorable for you – because fundamentally the market will determine how much a buyer is willing to offer for your company – you can reach out to buyers at the optimal time, for the optimal value.

Don’t hesitate on recasting

I hope you take this advice on recasting to heart. You’d be surprised how many entrepreneurs enter the exit process with just a “gut feeling” about how much their company’s worth. By undergoing a thorough business evaluation from trusted M&A advisors, you can instead start the process with more assurance.

If this is something you haven’t considered, I’d encourage you to speak to our team at Generational Group. We have been recognized several times as Valuation Firm of the Year by The M&A Advisor, and our professionals know not only how to find re-castable items; they do this with documentation that buyers respect and trust for its accuracy.

Working with our skilled professionals to recast your historic income statements and balance sheets could make a significant difference in the ultimate value paid for your company.

This guarantees that the first step on your journey to exit is one taken with confidence and clarity. But, even though failing to recast is certainly one of the biggest pitfalls to navigate on this journey, it certainly isn’t the only mistake often made.

That’s why our professionals at Generational are there for our clients from start to finish, from an initial evaluation and recommending growth strategies, to identifying and negotiating with ideal buyers.

If you’d like to learn more about recasting and the difference it makes, check out the wider insights available on the Generational website, or attend one of our excellent Growth and Exit Strategy Conferences.