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Are you paying yourself FMV rent?

Wagner

 

Most companies in the LBM sector have a separate LLC that owns the real estate where they have located their businesses. Since many LBM dealers have been around a few decades, that real estate is often owned free and clear. Sometimes, when you own your own real estate—and you own the company that is the tenant of that real estate—you may not be paying rent, thinking, “Why bother? It’s just my left hand paying my right hand.”

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That’s all well and good when you are running the operation, but non-payment or underpayment of rent is a genuine concern if you seek an acquirer. Here’s why: If you have been paying yourself no rent or rent that is below fair market value (FMV), your EBITDA is inflated in the eyes of the acquirer by the amount of rent you should have been paying all along.

For example, let’s say you have a business located within a real estate parcel that would rent for $20,000/month on a fair-market-value basis. Let’s also say you have paid no rent on that real estate. On a yearly basis, that $240,000 a year ($20,000 x 12) is going to your EBITDA. Because you are not paying fair market value rent, however, that EBITDA masks an expense that will be incumbent on the new owner. The buyer of that business will request that $240,000 be deducted from your EBITDA, to arrive at an FMV-rent-adjusted Adjusted EBITDA. This EBITDA adjustment is a negative to your EBITDA, as opposed to many other EBITDA adjustments that are typically positive adjustments.

Because your company will be valued in an acquisition at a multiple of EBITDA, that $240,000 ding can have a frightening effect. Let’s say that you were not paying the $240,000 in yearly rent, and your company is valued at 5X the Adjusted EBITDA. The underpayment or non-payment of rent will reduce the value of your company by 5X $240,000 or $1.2 million. Ouch.

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There is nothing unfair about the request from a buyer to true-up the Adjusted EDITDA to accommodate the underpayment/non-payment of rent. It’s only fair that the FMV rent is calculated into the company’s profitability. After all, when the buyer owns your business and starts to pay rent as your tenant, the rent is an expense, not EBITDA, and the effect this has on your company’s value can be quite shocking. As an investment banker that represents seller companies, our team always makes sure the fair market value rent is reflected in the Adjusted EBITDA line before the deal is even “put on the street.” This FMV rent issue is one that is never missed by an acquirer as they set loose teams of MBAs to pour over your books to make sure all the debits and credits are accounted for. So, it makes sense to state the FMV rent at the onset of any conversations with prospective buyers; take the hit early if you know it is inevitable.

The good news here is that if you are overpaying rent—perhaps in an effort to reduce the nut you have with the bank on your real estate—that is a positive credit to EBITDA, and you’d pick up the positive effect on the multiple paid for your company. For instance, if you were paying yourself $300,000 a year for rent, and the FMV was $240,000, that $60,000 different would be a positive credit to EBITDA, and you’d get 5X $60,000, or $300,000 increase in enterprise value.

If you are considering selling your business and have not had an FMV appraisal done, it’s advisable to do so. That report will show area comps and reveal the rent that should be charged. The report itself can then be an exhibit or addendum to the Confidential Information Memorandum (“CIM,” a.k.a. deal book) in case someone on the buyer’s team starts to question your rent assumptions.

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John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at j.wagner@1stwestma.com

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