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Normalization Adjustments in Business Valuation: Changing the Books
When performing a business valuation, it is not uncommon for the valuator to make normalization adjustments. These entries are intended to change certain financial data of a business to make the best possible estimate of the true economic earning power of the entity. Normalization adjustments often deal with items the owner or manager expends that are discretionary. These adjustments may also relate to unusual or infrequent transactions that are not typical to the business.
The extent of items normalized depends on the purpose of the business valuation. If the business is being sold outright to an unrelated buyer, the normalization adjustments may be different than a business that was admitting a minority shareholder.
One of the most frequently normalized adjustments is owner’s compensation. In the case of a very profitable corporation, for tax purposes, the owner may take out all the profits in the form of compensation. This compensation may be more than what the business would need to pay an independent replacement for that individual. Conversely, for a struggling business where the owner takes a meager salary, this compensation may be less than what would be needed for someone to manage the business. In both of these cases, the compensation may need to be normalized to an arms length replacement compensation level.
However, in the case raised above, where a minority shareholder is being admitted into the business, salary may not be adjusted at all. Since a minority owner is generally recognized as not having the authority to determine the majority ownership’s compensation, this would not be an area where normalization would occur. This theory may hold true with other items of expense when the primary ownership and/or management will continue to remain in control.
Perquisites are another frequently normalized item. Current management may wine and dine clients at the most lavish restaurants in town or take clients to every NFL home game, but these expenses may be more for the benefit of the owner than the company. In many cases, these expenses would be added back to the earnings of the business to determine a normalized profit.
Extraordinary or unusual items will also frequently be adjusted out of the data used in a business valuation. If a division of a business is sold for a profit, the gain from the sale of the division and any previous years’ profits or losses from that division should be removed from the calculations to arrive at a normalized profit. The same would be true if a business sold a portion of its property and equipment at a gain or a loss, unless the business typically and regularly engages in this type of transaction.
Items purchased at below-market prices should generally also be normalized. If a party related to the business provided goods or services that the business received at a discount (or premium), and this relationship would not continue after the business is sold, the goods or services would only be available to the new owner at market rates. One of the most common examples of this type of normalization adjustment is rent paid to the business owner or another related party. It is common for a business owner, sometimes in conjunction with others, to own the property from which the business operates. Consequently, the parties to the lease have other relationships which may influence the rent paid. In this setting, the valuator should scrutinize the lease document, and research fair market rents to determine if any adjustment to rent expense is warranted.
The goal of the process of normalization is to provide a fair and reasonable look at the business’ expenses from a completely unbiased perspective. Once this is accomplished, the result of the business valuation will be of greater value to all the parties involved.
By Jamie B. Hankins, Jr., CPA, ABV, CFF, CVA, Business Valuation & Litigation Support Shareholder
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