Quality of earnings: why the seller's profit is never the buyer's profit

Owner-operated businesses are run to reduce taxable income. That is rational and it means the profit on the tax return is not the profit a buyer will experience. Normalising it is the core of diligence. Add back the owner's compensation above or below market and replace it with what it costs to hire the role. Remove personal expenses running through the business — vehicles, travel, phones, family on payroll. Remove genuinely one-time items in both directions. Then subtract what the seller was not paying: rent at market if the seller owns the building, a manager if the seller worked sixty hours, software and insurance at real cost. Then test the revenue. Customer concentration is the single biggest risk in a small business purchase: a business where a few customers are most of the revenue is a business whose value depends on relationships that may belong to the seller personally. Ask for revenue by customer for three years and look at what changed. Working capital is the line that surprises buyers after closing. A business needs cash, inventory and receivables to operate, and if the deal does not specify a normal level of working capital delivered at closing, the buyer funds it on day one out of their own pocket. Bank statements and merchant processing records are worth more than a profit and loss statement, because they are produced by third parties. When the two do not reconcile, the reconciliation is the diligence. This article is general information, not legal, tax or financial advice. Rules change and every deal is different — check your own case with a licensed professional. Alberto Zaltzberg — Adonait · adonait.com