We started our discussion of business valuation with a post titled “Public Markets Provide Context for Private Company Valuation” and with comparisons of public companies because they provide the standard against which, either implicitly or explicitly, we value private companies.

In this post, we talk about normalizing adjustments to the income statements of private companies. However, we cannot talk about normalizing adjustments for the income statement outside the context of adjustments to the balance sheet.

The very word, normalize, suggests that there is a standard to which we are comparing. That is the definition of the word.

So what is the standard for normalizing the earnings of private companies? It is that of a well-run public company, where we assume that salaries and other expenses are set at market rates, and that discretionary expenses are minimized. If it were not so, i.e., if there were substantial expenses of a discretionary nature at a public company, there would be pressure from shareholders, even activist shareholders, or takeover pressure in order to capture the valuation benefit of these non-normal expenses.

As we will see, there are many things that can happen in a given year that might distort the pattern of earnings from the viewpoint of valuation or from the perspective of market participants. The purpose of normalizing adjustments is to show what earnings would be on a, well, normal basis.

Developing normalizing adjustments is a critical part of the valuation process, either for business appraisers or for market participants. It is also important for business owners, who need to understand the underlying earning power of their businesses.

Normalizing Adjustments

Appraisers put income statement adjustments into two categories, normalizing for discretionary, one-time, non-recurring, or other unusual expenses, and so-called “control” adjustments. Some appraisers argue that adjustments for discretionary bonuses, or non-pro rata payments to inside owners are “control” adjustments because minority owners could not force those adjustments to be made. I place such discretionary expenses in the category of normalizing adjustments and address their valuation impact in other ways.

The first kind of normalizing adjustments relate to one-time or unusual items on an income statement. These adjustments eliminate one-time gains or losses, other unusual items, discontinued business operations, expenses of non-operating assets, and the like. Every appraiser employs such income statement adjustments in the process of adjusting (normalizing) historical income statements. And every market participant looking to purchase a business will consider them.

Non-Recurring Items

The first category of normalizing adjustments, as noted, is that of one-time, non-recurring items. Such adjustments can be additive to earnings or can reduce earnings. Adjustments that might decrease normalized earnings include:

• One-time favorable legal settlement. If there was a one-time, non-recurring legal settlement of $400 thousand in a particular year, that item of income would be eliminated and earnings would be reduced by that amount.
• Life insurance proceeds. If a company owned a life insurance policy on the life of an owner who died, the proceeds would be considered non-recurring in nature and earnings would be reduced by that amount.
• Sale of a redundant asset. If a non-essential asset were sold, providing a significant gain in the income statement, that gain would be eliminated, and earnings reduced.

This list is, of course, only representative. Other adjustments could call for an increase in earnings, including:

• Non-recurring legal settlement. If a company paid a settlement and earnings were reduced, that amount would be added to income in the period in question.
• Write-down of accounts receivable. If there were a significant write-down of a customer’s receivable that is considered to be one-time and non-recurring, this write-down would be added to earnings in the relevant year.
• Inventory write-down. If there were a one-time write-down of certain items of inventory that is deemed to be non-recurring, this amount would be added to earnings.
• Charitable contributions. Some companies make discretionary charitable contributions. These contributions should be identified and the income statement adjusted accordingly.

There is little debate about the appropriateness of normalizing adjustments like those above that would either make positive or negative adjustments to earnings in a given year.

Discretionary Items

The second category of normalizing adjustments relates to discretionary expenses paid to or on behalf of owners of private businesses. These adjustments normalize owner/officer compensation to market rates for comparable services. They also adjust for other discretionary expenses that would not exist in a reasonably well-run, publicly traded company.

Some business owners, for example, pay themselves bonuses to avoid having to make distributions that might be taxed unfavorably in their taxing jurisdictions. Owners who pay such discretionary bonuses should realize that the above market portion of their compensation is not salary or normal compensation, but a return on their investment in the business. In a previous post, I talked about Martin and Steve, two business owners with similar businesses. Their examples might be instructive here.

Their businesses have $3 million in annual sales and generate discretionary cash flow to owners of about $600 thousand. A business appraiser concluded that normal compensation for their positions was about $200 thousand, and that normalized earnings were, in both cases, about $400 thousand. The appraiser valued each company at 5x normalized earnings, or at $2 million.

Martin fooled himself for many years, paying out the entire $600 of discretionary cash flow and living on that amount. He found that as he approached 65, he had little in savings and investments and was in no position to sell his business or to retire.

Steve, on the other hand, had lived on $300 thousand per year and invested the remaining $300 thousand (after taxes, of course) and had built up a substantial investment portfolio. He found that after selling his business, he would be able to retire and have a higher income than he and his wife had ever lived on.

Steve knew the difference between return on labor and return on capital, and Martin did not. Steve reinvested a significant portion of his return on capital from his business over many years and created wealth independent of his business. Martin did not and now is not in a good position to retire – at least at anywhere near the lifestyle he has been leading.

Owners will want potential buyers of their businesses to make normalizing adjustments for discretionary bonuses like those paid to Martin and Steve. But they must remember that when the adjustments are made and their businesses are sold, they will no longer receive that discretionary level of compensation.

There are other discretionary expenses that are sometimes normalized, including:

• Expenses associated with boats, expensive automobiles and other toys
• Expenses associated with non-working wives, children or girlfriends (yes, I’ve certainly seen that!)

Discretionary expenses associated with owners should be identified and appropriate normalizing adjustments should be made.

Wrapping Up

We’ve introduced the topic of normalizing adjustments in this post. In the next post, we will talk more about these important adjustments. In particular, we will talk about relationships between the balance sheet and the income statement and how they give rise to additional normalizing adjustments.

And If You Have an Interest

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In the meantime, be well!

Chris

Question: What is the most interesting or unique normalizing adjustment you have ever seen?