By Blake Seabaugh, CPA
No doubt dealers have speculated about dealership valuation of recently (if not frequently). Fueled by the frenzy of consolidation over the past ten years, one of the most common questions we hear in the M&A space is, “what is franchise X currently worth?”
Well, it’s not a simple (or cheap) answer. A myriad of factors goes into every valuation (we will discuss a valuation method based on a multiple of EBITDA in this article), but perhaps one of the most important is ‘normalized earnings’. Both parties try to adjust historical earnings to remove the effects of things like improper accounting, related party transactions, unusual items, non-operating income/expenses, etc.… and focus on just the core dealership profitability.
This exercise is as important for the seller – to assist in negotiations – as for the buyer – to support the dealership valuation. Here are five common adjustments to earnings, and buyer’s and seller’s related concerns.
- Compensation & “Fringe” Benefits
Compensation is an easy target as it is typically the largest line item on the profit and loss statement. Buyers will request pay plans during the diligence period and perform market comparisons to determine what outliers exist. The lowest hanging fruit is always an engaged owner/family member involved in the day-to-day operations but taking below-market wages – which creates an ‘overstatement’ of normal dealership earnings. On the flip side, buyers are also concerned with overpaid employees as they will be difficult to retain when presented with new pay plans aligned with the market. The buyer will fear that sourcing new talent will become an obstacle to a successful transition.
In addition to compensation, “fringe” benefits should be scrutinized by sellers. Items like family demos, country club dues, season tickets, sponsorships, and other entertainment expenses should be reviewed for their direct business purposes as these expenses (if non-essential) can negatively impact the value of the dealership if not adjusted.
- Related Party Rent
The two biggest areas of concern in related party transactions are rent and debt. However, assuming the valuation is based on a multiple of EBITDA (earnings before interest, taxes, depreciation, & amortization), related party interest expense will not be considered in normalizing earnings. Most buyers will focus on related party rents and will inquire about the following;
- Has an appraisal been performed to determine the fair market rental rate?
- Is a long-term lease agreement in place?
- Does the agreement have rent escalation clauses?
- If rent concessions were within the agreement, did the dealership appropriately record a straight-line rent liability?
Whether buyer will be purchasing the dealership real-estate or entering into a lease, the historical rent expense and the answers to the above will be a significant factor in the earnings quality of the dealership.
- Unrecorded Liabilities
Earnings can be overstated if unrecorded liabilities exist. Buyers may inquire about the accounting for chargebacks, customer loyalty programs, prepaid maintenance programs, storage programs (motorsport dealers), and any known environmental remediation costs (e.g., lift pits or tanks). Estimates of these liabilities, if not properly estimated and recorded, are common adjustments that may reduce earnings.
A search for unrecorded leases should also be performed. Sellers should review all lease agreements and confirm the appropriate accounting treatment is recorded. Buyers will want to review 12 months of accounts payable detail and analyze significant recurring items for potential unrecorded leases to determine what impact(s) are on earnings quality.
A common formula will use a weighted forecast of EBITDA in determining average earnings. Used vehicle and parts inventory specific adjustments need to be made in this scenario as the related write-downs will be charged to the forecasted period. Buyers will review parts inventories for significant obsolescence or slow-moving items and utilize wholesale valuation guides to determine if any negative equity exists in used vehicles.
- F&I Products
This is often a difficult area to assess because (in some arrangements) not all the F&I profitability is recorded at the dealership. Some can be redirected to employees or owners so it’s not enough to just analyze total F&I gross profit per unit. Adjustments should be made if providers are paying spiffs directly to F&I employees (also impacts compensation discussed earlier) or if over remits are directed back to the owners instead of the dealership (it’s the dealership’s profit).
The discussion above highlights some of the more significant areas. While you may find numerous adjustments during the diligence period, keep in mind that any adjustment to the quality of earnings is amplified by the multiplier (small changes save big $$$). Thus, an investment in due diligence can create significant value for a seller or perhaps save a buyer from overpaying for an underperforming asset.
Blake Seabaugh is a Tax Manager at Perkins & Co., an accounting firm based in Portland, Ore. He can be reached at 1-503-221-0336 or BSeabaugh@perkinsaccounting.com.