There are many reasons for a client to need to determine the value of a company. Revenue Ruling 59-60 is the impetus for all business valuations (appraisals). There are three approaches that are utilized to value a business. The three approaches are the Asset-Based Approach, Income Approach and the Market Approach. Underneath each approach there are many business valuation methods that can be used to determine the value of a company. The various methods will typically require some normalizing entries. For the income methods, normalizing adjustments are made to determine the future ongoing earnings capacity of a business.
Normalizing adjustments adjust the income statement of a private company to show the prospective purchaser the return from normal operations of the business and reveal a “public equivalent” income stream.[1] If such adjustments were not made, something other than a freely traded value indication of value would be developed by capitalizing the derived earnings stream.
The some of the major classifications for normalizing adjustments are: (1) converting the financial information to Generally Accepted Accounting Principles (“GAAP”), (2) extraordinary items, (3) nonrecurring items, unusual items, (4) discontinued operations (5) discretionary items. Typically the financial statements are recorded in Excel and the above items are considered for adjustments then anomalies are located, questioned and possible normalizing entries are made.
Oftentimes, adjustments to the income statement will increase a business’ earnings stream, and in some cases it will decrease earnings. Potential adjustments to income statements commonly relate to:
Owner’s compensation, payroll taxes, and benefits (pension plan, etc.) that exceed reasonable market rates (replacement salary). Sometimes adjustments are made because owner’s compensation is below market rates.
Non-recurring income and expenses, such as; (i) lawsuits; (ii) uninsured events; (iii) gain or loss on a sale of assets; and/or (iv) extraordinary issues. This list can be endless; remember each adjustment must be supported by the facts.
Non-operating income and expenses must be addressed, such as discretionary expenses to reduce taxable income. Issues like family members receiving a pay check when they do not actually work in the business. Any items unrelated to the business’ actual operations or that do not provide fair value for their compensation level (e.g., university, vacation, second home, and condo payments, etc.).
Expensing versus capitalizing of various costs (e.g., leasing of equipment).
Non-cash charges (e.g., accelerated depreciation and amortization).
Related (inner family) sales or expense arrangements. An example would be an owner of the company leases property back to the business. If any arrangements do relate to a business’ core operations, and are not at arm’s length, adjustments should be considered at prevailing market rates.
The normalizing entries are an important process in performing business valuations as they provide information for the future earnings capacity of the business. Historical financial statements are not representative of future earnings capacity, especially if personal expenses are being recorded on the books and records of the company.
In a recent engagement, the opposing expert normalized the owners compensation on what management believed was reasonable compensation. This is an incorrect measure of compensation. The owners compensation is what you could replace the individual with a reasonable compensation. This information should be obtain from third party, independent information. There are a number of databases that contain compensation studies.
In the same engagement, there were minimal normalizing entries. The opposing expert stated in a deposition “Pretty immaterial I think it’s like a couple-thousand dollar difference, but…”. When a company is being valued, it is a hypothetical value with the assumption that the seller will sell the company. The seller will always want to maximize the amount they will receive for the company. This is based on maximizing the cash flows to an owner. A couple of thousand dollars (for how many adjustments not made) can have a material impact on the cash flow and therefore the value of a company.
The following Exhibit 1 demonstrates the impact of not doing the due diligence on the operating expenses. In the example provided, would the owner of a company accept the idea that not normalizing the operating expenses would be acceptable and that the sell would be willing to accept a lesser amount, just because the business valuation expert, thought in their opinion, that searching for and making the normalizing adjustments was immaterial?
Many in the profession believe there are two types of adjustments. On one side, appraisers believe a minority interest that does not have prerogatives of control and these appraisers do not make any adjustments because minority interests do not have the implicit right. On the flip side, some appraisers believe minority interest adjustments are warranted on two levels.
At the first level (type 1 adjustments), majority ownership (greater than 50%) has a duty to operate the business for the benefit of all interest/shareholders whether minority or majority. With that thought process, adjustments are made for excessive expenditures like overpayment of related party rent, non-operating expenses, compensation, etc. No discount for lack of control is applied in this case.
At the second level (type 2 adjustments), these adjustments are made that only a majority shareholder can control, such as, paying dividends, changing the capital structure of the business, etc. These appraisers then apply a lack of control discount to the minority interest (50% or less) being valued.[2]
Deposition or Trial Questions for Attorneys
Question: Verify that the expert believes that normalized adjusting entries should be made to determine the earnings capacity and ultimately the value of a company.
Answer: Should be yes.
Question: Ask what data base was used to adjust the owners and family members compensation to a replacement compensation. (Have them produce this analysis from their workpapers).
Answer: They should be able to produce the analysis. Otherwise there is no reasonable analysis to support their conclusion.
Question: Ask what specific items were normalized related to discretionary expenses.
Answer: They should be able to provide information and reasoning for each item.
Question: Ask if they normalized any personal expenses that were deducted on the company financial statement and tax returns.
Answer: They should be able to provide information and reasoning for each item.
Question: Ask if the company has any related party transactions from rental property or leases
Answer: If yes, the expert should have supporting documentation for adjusting these items to fair market value.
[1] Mercer, Christopher, ASA, CFA. “Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation”. Published by Peabody Publishing, LP @ 2004 Z. Christopher Mercer. P. 149-151
[2] Mercer, Christopher Z. “Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation”, Peabody Publishing LP, © 2014, p. 150.