One common step in all business valuations is the “search for adjustments” – whether it be a public company with GAAP accounting or a small pass through entity. Valuation analysts are (almost) always looking at past performance as a proxy for future value. In doing so, we need to understand what the “real” earnings capacity of the company is. Unfortunately, the story isn’t always so clear. Myriad factors cloud the question of “what’s real?” Nonetheless, analysts work through a process to start quantifying these changes – or Adjustments – to earnings to realizing the real number. From there, we can work through modeling performance, risk, and ultimately value.
Why do we care? A few reasons:
- Adjustments can have a material (and sometimes downright huge) impact on value
- Adjustments can have a negative connotation – often impacting “sale-ability” in a transaction
So… we agree adjustments are important. So how do we determine them?
Identifying Normalizing Adjustments
First let’s classify these Adjustments. Broadly speaking, Adjustments can often be grouped into two categories:
- One-time or Non-recurring Expenses
- Discretionary/Personal Expenses
Of note, the purpose for the valuation often guides what Adjustments are reasonable. As we’ll discuss below, while some adjustments might be justified when valuing a company as a whole, the same line item might not make sense for a fractional interest in the same business.
One-time / Non-recurring Expenses
One-time or non-recurring expenses are just what they sound like: line items that are not likely to occur again. FASB provides some helpful guidance to flesh these out. The Accounting Principle Board Opinion No. 30 defines an extraordinary item as one that is:
- Unusual in nature – the underlying event or transaction should possess a high degree of abnormality and be a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates
- Infrequent in occurrence – the underlying event or transaction should be a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.
How does an analyst identify these adjustments? Oftentimes these expenses can be identified by performing year over year trend analysis to understand what a normal level of expenditure for the Company should be. However, in rare occasions these expenses may be masked due to internal account classifications and can only be quantified through discussions with the Company’s management. Typical one-time/non-recurring expenses could be the result of litigation engagements, professional/consultant fees, the capital gains or losses from the sale of assets, non-cash expenses such as the built-in tax gains from those sales, and section 179 depreciation.
Many closely held businesses will include various discretionary/personal expenses on their financial statements. They may include above/below market owner compensation and employee salaries, ownership perks and fringe benefits, and any other expenses that are not core to business operations or otherwise likely to be incurred by a would-be acquirer.
In pass-through entities, officer and ownership compensation is frequently normalized due to its discretionary nature. In practice many owners pay themselves simply what the business can afford rather than the market rate for the services they perform. Ultimately this is often what we think of as a “dividend in disguise.” The analyst should ascertain a fair market value level of compensation for the services rendered and adjust the excess. For instance, Company XYZ pays the owner $500,000 for his services annually. However, fair market value rate of compensation for someone to perform the services of the previous owner is $150,000 – thus resulting in an adjustment of $350,000 to the Company’s financial statements to reflect the true economic benefit stream available to the acquirer.
Additionally, payroll salaries for “ghost” employees – that is employees who are on the Company’s payroll but do not actively participate in the operations of the business, may exist and need to be adjusted out. Oftentimes these are family members who receive some level of compensation from the company without employment capacity.
Sometimes a business will incur expenses that are not central to operations. As an example- a recent client had been funding startup and development costs for a sister company with common ownership. These expenses are not related to the operations of the company and as such are a frequent target for adjustment.
In addition to officer compensation, many business owners will often expense personal items to the company. Putting aside the ramifications of doing so, simply put these are not operational expenses and are targets for adjustment. Typical examples might include personal car expenses, travel and meal expenses, certain professional fees, and other expenses that benefit the owners/officers that deviate from the normal costs of operating the business.
Illustrating Normalizing Adjustments
Analysts must adjust the financial statements or income tax returns of a business to most accurately derive an income benefit stream that can be capitalized. Depending on the company, its historical financial statements and “adjusted/normalized” financial statements can diverge significantly, thus resulting in a significant difference in the overall value. Additionally, normalizing the financial statements allows the analyst to make comparisons to similar companies and industry averages as well as make meaningful projections and forecasts.
Below are the historical income statements for Company XYZ. Note that the Company is a pass-through entity and does not pay taxes at the corporate level.
The Fact Pattern
Understanding the following fact pattern, we can identify several normalizing adjustments –
- The Company has two owner/officers that receives compensation. Bob is the majority owner with 80% ownership in the Company and Mike is a minority owner with 20% non-voting ownership. The market salary rate for the services that both officers perform would be approximately $150,000 each.
- The Company had a one-time settlement fee of $100,000 for a lawsuit in early 2017
- The Company received a five-year lease renewal discount for FY17 paying half of the fair market value rent.
- Bob has opened a new Hawaii office in 2017 with a yearly cost of $80,000. However, there really is no business there and it is more of a perk than an office.
- Bob and Mike took several vacations this year and booked their personal travel and meals in meals and entertainment. Meals and entertainment with clients typically amount to $35,000 on average.
- The Company had accelerated depreciation under Section 179 for an operating asset purchased at $100,000 in FY17; This asset has a depreciable life of 10 years and is more appropriately depreciated using a straight line convention
- Bob employs his sister at $57,000 per year – however this is a “no-show” job.
We account for these discretionary/one-time expenses by normalizing the above items below.
Once the analyst has normalized the Company’s income statement, the resultant “adjusted” income statement reflects the true economic benefit stream an acquirer can expect to inherit. See below.
Normalizing the financial statements results in an adjusted earnings before interest, taxes, depreciation and amortization expense (“EBITDA”) of $1,422,000 – an increase of 112.2% on the most current year’s income benefit stream!
Impact on Value
Below we present a simplified market approach analysis that capitalizes the benefit stream (EBITDA) in the most recent year by comparing similar companies that have recently been transacted.
With the guideline companies analyzed, the market approach implies an EBITDA multiple of 5.0x. Capitalizing FY17’s income benefit stream results in an increase in overall value of $3,760,000 for the subject Company XYZ – further emphasizing the necessity to account for any one-time/non-recurring or discretionary expenditures.
Minority Interest? Not So Fast
Ok, so this all makes sense. If there is additional cash flow available to a “willing buyer,” then we should account for that cash flow in modeling. But what if we are valuing Mike’s 20% interest? Recall from our vignette that Mike does not have any voting rights on “control” provisions in the business. While Bob is a “good guy” and generally takes care of Mike, can Mike force his partner to stop paying Bob’s sister? Can he close down the unneeded Hawaii office? What about Bob’s compensation? In our case, no. Knowing that Bob and Mike take equal salaries, we need to re-look our adjustments- reducing the amount we adjusted by a total of $387k, $57k for Bob’s Sister’s compensation, $80k for the Hawaii perk, and $250k for Bob’s compensation.
Here is the impact on value:
What About Sale-ability?
As companies get larger they often adopt better governance practices and comply with GAAP requirements. Not so with smaller entities. Often times owners will treat a company as their own “piggy bank”- running all variety of expenses through the business. (True story: we once saw a six-figure race horse expensed to a fire sprinkler company!) While we can (and do) certainly make adjustments for these sorts of truly non-business related items, the bigger issue is that they create a sense of doubt for a buyer. After all, if the company is so cavalier with their financial reporting as to expense a racehorse, what other shenanigans are going on? In our experience, buyers tend to walk away from situations where adjustments are either very aggressive or where they are a material portion of earnings.
Bottom line for owners- clean up your financials well in advance of an exit! It’s better to not rely on aggressive adjustments in order to try to substantiate your purchase price.
Every valuation assignment involves the search for adjustments. Our goal is to understand what the real, ongoing cash flow performance of the company is – and that flows through to value. That said, unlike our vignette, the process is far from straight forward. Special attention needs to be paid to getting the details right with adjustments. And as a business owner, it might be even more important to think about how cleaning up financials will correlate to both value and sale-ability as you get close to an exit!