Cleaning Up Your Financials Before Going to Market

The most valuable preparation an owner can do before a sale is to make the financial records agree with each other. Buyers pay for earnings they can verify, and lenders finance only what the tax returns support. A business with modest earnings and clean records will often sell faster, and on better terms, than a more profitable one whose numbers require explanation.

What buyers and lenders will ask for

The core request list is consistent across nearly every transaction.

• Three years of federal business tax returns
• Three years of year-end income statements and balance sheets
• A year-to-date income statement and balance sheet, with the same period from the prior year
• Monthly income statements for the trailing twenty-four months
• Accounts receivable and accounts payable aging reports
• A fixed asset list
• A debt schedule
• Payroll records and a current employee census

A buyer who receives all of this in an organized form within a few days draws a conclusion about how the company is run. So does a buyer who receives it in pieces over six weeks.

The first test: do the statements match the returns?

Lenders underwrite from tax returns. Buyers and advisors usually work from internal statements. When revenue or net income differs between the two, someone has to explain why.

Some differences are ordinary. A company may keep its books on an accrual basis and file on a cash basis. Depreciation methods differ. Those can be reconciled on a single page.

Unexplained differences are a problem. If the internal statements show $1.9 million in revenue and the return shows $1.7 million, the lender will use the return, and the buyer will wonder about the gap. Preparing the reconciliation in advance, for each of the three years, removes the question before it is asked.

Separate personal from business

Running personal expenses through the company lowers taxable income, and it is common. It also lowers the reported earnings a buyer and lender can see.

These expenses can be added back, but every add-back is a point of negotiation and a documentation burden. An owner planning to sell in two years is usually better served by paying personal expenses personally. The additional tax is real, but each dollar of documented earnings is multiplied in the price.

Fix the balance sheet

Owners watch the income statement closely and the balance sheet rarely. Buyers read both. Several items deserve attention.

Receivables. Write off balances that will not be collected. An aging report with invoices outstanding for two years suggests either a collection problem or poor housekeeping.

Inventory. Take a physical count and remove obsolete items. The book figure should reflect what is on the shelf and saleable.

Shareholder loans. Amounts due to or from the owner should be documented, and usually settled, before closing.

Fixed assets. Remove equipment that has been sold or scrapped. Identify any assets used in the business but titled personally.

Accrued liabilities. Record unpaid vacation, customer deposits, warranty obligations and sales tax payable. A buyer will find them, and unrecorded liabilities reduce trust more than they reduce price.

Produce monthly statements on time

A monthly close, completed within two or three weeks of month-end, serves two purposes. It lets a buyer see seasonality and trend. It also demonstrates that the company has a functioning finance process a new owner can inherit.

Monthly detail matters most during the sale itself. Diligence takes two to three months, and the buyer and lender will ask for updated results each month until closing. A company that cannot produce them stalls its own transaction.

Decide on the level of outside review

Most Main Street companies have compiled statements or only tax returns. That is normally sufficient for a sale under $2 million.

As deal size grows, reviewed statements become worthwhile. For larger transactions, a seller may commission its own quality of earnings analysis before going to market. This identifies problems while there is still time to address them, and it shortens the buyer's work. Under current SBA rules, acquisitions of $3 million or more financed with a 7(a) loan require an independent report prepared for the lender, so a seller-commissioned analysis supplements that review and does not replace it.

Resolve known tax and compliance issues

Open items with tax authorities delay closings. Sales tax exposure in states where the company has customers, misclassified contractors, unfiled returns and payroll tax notices should be addressed in advance. The cost of resolving them is nearly always lower than the escrow or price reduction a buyer will demand to cover the uncertainty.

A workable timeline

Twenty-four months out: stop personal spending through the company, begin monthly closes, and review the balance sheet with the accountant.

Twelve months out: prepare return-to-statement reconciliations, assemble the add-back schedule, and resolve open tax matters.

Three months out: organize documents into a data room, update the fixed asset and debt schedules, and confirm that year-to-date results are current.

Owners with less time should still do the reconciliations and the balance sheet cleanup. Those two steps address the questions that most often slow a deal.

Clean records do not make an average business exceptional. They allow a buyer to pay full value for what is there, without a discount for what cannot be confirmed.

Twelve31 Advisors reviews financial readiness with owners well before a sale process begins, and maintains a secure data room for each engagement.