How much is a business worth? You may need the answer if a business is owned by your client or the opposing party in marital dissolution. In my new book, “Introduction to Business Valuation for Matrimonial Lawyers,” I look at several of the most common ways to value a business.
A major component of determining the value of a business through the income approach is making normalization adjustments. Normalization adjustments are modifications to the financial statements to accurately reflect the benefit a future buyer/investor will receive. There are many possible adjustments to be made, two main categories are control adjustments and accounting/non-recurring adjustments.
Control Adjustments
A shareholder who has a controlling interest in a company has the ability to make decisions that minority shareholders cannot. These interest holders have the ability to use company resources (i.e., cash) for reasons that differ from how companies in similar industries or a future owner may use resources. The use of cash by the controlling shareholder may be for the benefit of the shareholder and not the company, making an adjustment necessary to reflect the fair market value of a business.
Some examples of control adjustments are owners’ compensation, rent, and personal expenses paid for the benefit of the owner. If the owner pays themselves or others an unreasonably high or low salary, an appraiser will look at market data for the salary of their potential replacement. Rent expense is another likely normalization adjustment. The business owner may also own the building that the company operates out of and pays rent to, and oftentimes, the rent paid in these arrangements doesn’t reflect market rental rates. Lastly, the company may be paying personal expenses for the benefit of the owner.
Appraisers should consider making these adjustments because the fair market value standard of value includes a “willing buyer” concept. It is unreasonable to expect a prospective owner to willingly overpay company expenses. It is the appraiser’s responsibility to adjust owners’ compensation and rent to reasonable market rates and remove personal expenses. Doing so creates a more accurate reflection of the future benefit a prospective owner will receive.
Accounting/Non-Recurring Adjustments
Adjustments related to accounting conventions primarily involve changes to how a company records its financial statements. Small businesses have the option to record transactions on the cash basis for income tax purposes, but the cash basis does not always reflect the true economic activity of a business. In order to ensure financial statements reflect their true economic value, adjustments may be needed. Examples of common accounts needing adjustments include revenue, cost of sales, and current assets/liabilities.
It is the job of appraisers to determine the future benefits that will be received by a prospective buyer. Any significant income or expense that will not reoccur should be removed from consideration. Examples of non-recurring income include COVID-19 relief programs – Paycheck Protection Program (PPP) loan forgiveness and Employee Retention Credit (ERC). The forgiveness of PPP loans and receiving an ERC is not expected to continue into the future and should be remove from normalized income. Other examples of non-recurring adjustments are gains/losses on disposal of assets. The company disposing the assets is not likely to do so in every future year, so it should be removed as a non-recurring adjustment.
How about you?
Normalization adjustments are an integral part of calculating the income approach. Without them, the future benefits of the company will not be accurate, and the overall value could be overstated or understated. It is vital that while reviewing a valuation, you ask yourself if the adjustments are reasonable and if they have an adequate foundation.
Interested in more?
If you have found this helpful and want to dig deeper on this subject as well as delve into to others consider purchasing my book – Introduction to Business Valuation for Matrimonial Lawyers. This is primer on business valuation written directly to and for attorneys.
