Historical operating income of private companies often requires adjustments in order to present a number that a buyer can reasonably expect going forward. We call these “normalization adjustments”. 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.
Common normalization adjustments
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.
Too many is a red flag
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.