When valuing a closely held business, reported net income is often only the starting point. Financial statements and tax returns reflect the actual transactions of a company, but those transactions may not necessarily reflect the earnings expected from the business going forward.
This is particularly relevant for small, owner-operated businesses, where owners often have significant discretion over compensation, benefits, related-party transactions, and other expenditures.
As part of the valuation process, a valuator analyzes the company’s historical financial results and considers whether adjustments are necessary to develop a reasonable indication of the company’s ongoing earning capacity. These are commonly referred to as normalization adjustments.
Whether a valuation is being performed in connection with a matrimonial matter, a gift of ownership interests, estate planning, or another purpose, understanding these adjustments is an important part of the valuation process.
Owner Compensation
Owner compensation is a common consideration when valuing an owner-operated business. Unlike an employee of an unrelated company, a controlling owner may have significant discretion over the amount and form of their compensation. As a result, the compensation reported on the company’s financial statements may not reflect the market cost of replacing the services performed by the owner. A valuator may consider the owner’s responsibilities, industry, company size, geographic market, and other relevant factors in determining whether an adjustment to reasonable compensation is appropriate.
Importantly, the adjustment can work in either direction. An owner receiving compensation above market levels may result in an increase to normalized earnings, while an undercompensated owner may require an additional expense to reflect the market cost of their services.
Personal and Discretionary Expenses
Closely held businesses may also pay expenses that provide some level of personal benefit to the owner. Examples may include certain automobile, travel, meals, insurance, cell phone, or other expenses.
These expenses should not automatically be added back simply because they benefit an owner. Instead, the nature and business purpose of the expense should be considered. If an expense is not necessary to support the company’s ongoing operations an adjustment may be appropriate.
For attorneys involved in matrimonial matters, these expenses may warrant particular attention because the same transactions can be relevant to multiple aspects of the financial analysis, such as owner’s compensation.
Nonrecurring Income and Expenses
Historical financial statements may include income or expenses resulting from unusual events, such as significant litigation costs, relocation expenses, unusual repairs, or gains and losses on the sale of assets.
Determining whether an item is truly nonrecurring requires more than identifying something that occurred in only one year. A company may incur different “one-time” expenses every year. While a particular expense may not recur, some level of unusual expense may nevertheless be a normal part of operating the business.
The valuator, therefore, considers the nature of the transaction and the company’s historical experience when determining whether an adjustment is appropriate.
Related-Party Transactions
Related-party transactions are common among closely held businesses. An operating company may rent its facility from an entity owned by the same shareholder, employ family members, maintain shareholder loans, or conduct business with other commonly controlled entities.
The existence of a related-party transaction does not automatically require an adjustment. Instead, the valuator considers whether the transaction reflects terms that would reasonably exist between unrelated parties.
For example, if a business pays rent to a related entity at an amount materially above or below market, an adjustment to market rent may be appropriate when determining normalized earnings.
Adjustments Do Not Always Increase Earnings
The term “add-back” is sometimes used interchangeably with normalization adjustment, but the two are not necessarily the same.
A normalization adjustment can increase or decrease earnings. Removing a personal expense paid by the company may increase normalized earnings, while adjusting an undercompensated owner’s salary to market levels could decrease them.
The objective is not to maximize or minimize the value of the business. Rather, adjustments are intended to develop financial results that reasonably reflect the company’s ongoing economic performance.
Why the Details Matter
Normalization adjustments demonstrate why a business valuation involves more than applying a multiple to reported earnings. Financial statements and tax returns provide important information, but they do not always explain why a transaction occurred, whether it is expected to continue, or whether it reflects market terms.
For attorneys, identifying these issues early can help determine what financial information may be relevant and where additional inquiry is warranted. For business owners considering a gift or other transfer of an ownership interest, maintaining clear records surrounding compensation, related-party transactions, and unusual expenses can help support the valuation process.
Ultimately, normalization adjustments help provide a clearer picture of a company’s ongoing earning capacity and, in turn, the value of the closely held business.
The Business Valuation team at DiSanto, Priest & Co. has extensive experience analyzing closely held businesses and the unique financial considerations that arise in business valuations. Whether a valuation is needed for matrimonial litigation, gift and estate planning, or another purpose, our team can assist in navigating the valuation process and evaluating the financial factors that may impact value. Please call us at (401) 921– 2000 or contact us here.