Tag Archives: divestiture

Normalization Adjustments for Private Companies

Historical operating income of private companies often requires adjustments in order to present a number that a buyer can reasonably expect.  Profitable private companies will try to minimize their taxes payable.  This is simply good business practice.  However, one must be reasonable; for example, the spouse of an entrepreneur is paid $100,000 per annum for bookkeeping services.  In a small company that may be overpaying him/her and it may just be an approach to lowering household personal income tax; whereas, if he/she were to be an accredited accountant in a large company, it may even be underpaying him or her.  The tax authorities apply reasonability tests; the latter is reasonable, the former may not be.  Since tax minimization usually results in lower income (and therefore lower income tax payable); the adjustments will increase EBITDA and thereby provide the basis for a higher valuation of the company.

Adjustments are generally made for one-time events, discontinued parts of the business (or parts that are not being sold) and ongoing expenses that are either not necessary to run the business or not at market pricing.  Some examples of one-time items include start-up costs, certain product development/deployment costs, costs associated with new legislation or regulations, and lawsuits.  Ongoing expenses may include superfluous expenses such as luxury cars, boats and planes, summer homes expensed as regional offices, payments to family members not fully engaged in the business or at rates above the market rate, business trips that are really/mostly family vacations, personal tax and legal advise and personal bonuses or dividends that would be at the new owner’s discretion.  Conversely, when times are tough, entrepreneurs may pay themselves less thereby smoothing the impact of volatile revenues.  Entrepreneurs may wish to exclude bad debts or legal fees that they feel are excessive but in most cases these are recurring and necessary business expenses and therefore should not be eliminated.

Normalization adjustments are a delicate matter.  Too many and it becomes a red flag, raising concerns such as, “what are they trying to get away with here?” or, “with so many adjustments, does this reflect poor customer/supplier relationships? or, “there is probably more to it than that, I wonder what they are not telling me?”.  If your adjustments are not viewed as legitimate you lose a tremendous amount of credibility and negotiating power.  Also, what normalization adjustment should not do is make assumptions about a particular buyer and suggest that the business can run without certain expenses that a particular buyer might not incur.  This is the value to a buyer that you can point out in discussions but a buyer will rarely pay for improved prospects that it can bring to the table unless it is forced there by way of a competitive auction (see “What Will a Strategic Buyer Pay?”).

So far we have talked about income statement adjustments, because they are the main value driver, but we must also look at the balance sheet.  The company’s competitive position and economic prospects drive the valuation but then a balance sheet that is different from what is expected/required will result in adjustments to this valuation.  Redundant assets should be stripped and, on the other hand, if productive assets need to be replaced then adjustments may be required that have a negative impact on valuation.

12 Situations to Avoid When Selling Your Business

I have illustrated from time to time why sellers make certain choices as to when and how they pursue the sale of their businesses.  Here I will group the common scenarios to avoid.

A Must Sell Situation
Selling on strength should be your goal but be mindful that the selling window can close anytime.  If you are in a must-sell situation it is critical not convey this urgency and to leave potential buyers with the impression that time and options are on your side.

Not Managing the Process in a Timely Manner
If a buyer feels that the business has been for sale for a long time he/she may conclude that there are no other interested buyers and the auction aspect will be lost resulting in a low bid.

Critical Reliance on the Seller
Before a sale an owner-entrepreneur responsibilities and relationships should be migrated to a management team that will stay with the business; otherwise he or she will have to remain for an extended transition period.

Restricting the Buyer Universe
For an owner entrepreneur to not want to approach a key competitor is fine but to restrict the potential buyers to two or three possible buyers can be a critical mistake.  In “Finding a Buyer: It is Rarely the One You Expect” I outline the numerous reasons why a potential buyer will not be the actual buyer.

Unrealistic Price Expectations
The seller and M&A advisor should understand and agree on fair value before the selling process begins.  Once the process begins it becomes about soliciting strategic buyers, creating that competitive bidding tension and realizing the highest price possible.

Lack of Specificity in the Letter of Intent
Signing the LOI is a turning point in the process where the negotiating power switches from the seller to the buyer; it is the point where you grant exclusivity to the buyer and proceed to full legal documentation.  Therefore, a clear and complete LOI can save expensive legal negotiations.

Proceeding With an Unfunded Buyer; No Counter Due Diligence
You are taking a substantial risk when you rely on a buyer that assures you he/she can get financing or that the funding will come from the sale of another asset that is imminent.  Due diligence and legal documentation are time consuming and expensive processes that should not be pursued in a contingent environment.

Ignoring the Soft Factors: Can You Work With These Folks?
When an earn-out is in play that will see the buyer and seller working together for a substantial period of time, the seller needs to examine if the prospective working relationship will support the ability to achieve the earn-out.

Neglecting Day-to-Day Operations
The selling process can be extremely time-consuming for the seller and a transaction is not done until all of the documents are signed and the cash is in the bank.  If the seller is also responsible for business development, the M&A process can be distracting to the point of affecting the business’s operating performance.

No Plan B
One of the M&A advisors responsibilities is to provide options and to keep options at hand until closing.  Without a workable plan B, a process can die simply from exhaustion.

Overly Aggressive Seller Forecasts
The selling process is one that takes seven to ten months to complete and therefore you will always run into the question of: “are you on track”.. “can we have a look at the latest quarterly numbers?”  To underperform at this point is a worst case scenario.

Engaging the First Unsolicited Offer
Don’t feel that you have to engage a major supplier or customer when they make an unsolicited offer.  If potential buyers use pressure tactics to force a transaction it may be best to bring in a third party intermediary to manage the relationship and introduce other potential buyers.

There are many scenarios to avoid when selling your business.  An experienced M&A advisor will manage the process in a diligent, thorough and timely manner to avoid the pitfalls and realize optimal value.