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Business Owner Objectives - Running Business vs. Selling Business

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You're running a small business. The rule is simple: grow your sales and keep your expenses down, right? - Not so fast...

Growing your sales and keeping expenses down increases your taxable income. No business owner likes it. Higher taxable income means sharing bigger portion of your hard-earned money with Uncle Sam. Every business owner selects his or her comfort zone in tax management activities, ...and who am I to judge them.
 
You probably heard well-known quote: "Small businesses don't make money, but their owners do". It explains very well objective of "tax management" employed by majority of business owners*. Your business can pay for many things that you, business owner, need, thus increasing expenses and reducing taxable net income. Thus, your tax management objective is reduction of taxable net income. It may work well and provide you with decent discretionary earnings for years.
 
Discretionary cash flow is a combination of the net income and all discretionary expenses that were charged to a business, and is the only true indication of your small business' performance. For example, your net income is $100,000, plus payments for your personal car are $25,000, personal health insurance is $10,000, and personal phone is $2,000. Your total discretionary cash flow is $137,000.
 
Now, when you decided to sell the business, your objectives are quite opposite. You need to show as much discretionary cash flow as possible because your selling price is a direct function of it. One can raise discretionary cash flow by increasing net income, or discretionary expenses, or both. Net income from your income statements matters a lot because it influences your business' bankability. When the buyer decides to go after acquisition loan, banks will be evaluating your income statements for ability to handle new debt, and stated net income will play a big role in their decision to service the loan.
 
So, what you have to do to get the best of both worlds? Start planning your exit in advance, preferably three years prior to sale. Get into a selling mode and start showing as much income as possible, and, yes, start paying higher taxes. Don't worry, higher taxes will be well-compensated by considerably higher purchase price for your business. Of course, your accountant may advise you about legal tax sheltering techniques, like contributions to a retirement plan, that will still allow you to save on taxes, yet it's a topic for the next article.
 
So long,
 
Jacob Berenfeld
* This article discusses small and medium size private companies. Public company performance is driven by earnings, thus their objectives are quite different.

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Guest Sunday, 20 August 2017