​“Well,” the owner might sheepishly begin while looking over his shoulder to ensure no one is listening, “this year’s income statement reflected $2.5 million of net profit, but it actually makes much more because we run a lot of expenses through it to reduce earnings and taxes.”
How should the appraiser respond?
- Aghast at the owner’s mendacity for manipulating earnings to avoid paying income taxes!
- Sympathetic because the IRS gets too much already.
- Unsurprised because the IRS permits companies to write off non-recurring, discretionary, non-market, and other non-operating expenses, and there is nothing wrong with recognizing allowable costs.
If you chose c), you answered correctly.
Unlike public companies, which aim to report the highest earnings possible to boost stock prices, private companies often report the lowest earnings legally possible to minimize taxes. They achieve this by incorporating IRS-allowed expenses that reduce taxable earnings.
But if owners reduce taxes by inflating expenses, how can valuation analysts determine what private companies are worth? Internal Revenue Code 59-60 directs appraisers to normalize financial statements to reflect private companies’ true economic earnings power. A company’s true economic earnings power depends on its historical and expected benefit streams after adjusting for non-recurring, discretionary, non-market, and other non-operating expenses. Let’s unpack that sentence.
What is a company’s true economic earnings power?
 Buyers of privately held companies invest capital hoping to generate returns from two sources:
- Cash generated from business operations during the holding period and
- Appreciation when they sell the business in the future.
EBITDA (pronounced ee-bit-dah in the north and eh-bit-duh in the south) is shorthand for earnings before interest, taxes, depreciation, and amortization. It is a standard benefit stream used in the merger and acquisition industry to determine a company’s economic earnings power and value. The valuation formula using EBITDA is:
EBITDA X Risk Factor = Value.
The risk factor is known as a multiple of EBITDA and is found by comparing transactions involving similar private companies.[1]
To illustrate the earnings power and the normalizing concept, assume a company reported $5 million in EBITDA last year and that similar companies recently sold at seven times the EBITDA. One might conclude that the business is worth around $35 million ($5 million X 7).
However, suppose the company had $2 million in non-recurring expenses due to relocating to a new facility. Without these non-recurring expenses, EBITDA would have been $7 million, raising the expected sale price to $49 million ($7 million X 7), a $14 million increase! This example shows how normalizing financial statements can significantly impact a company’s value.
How are income statements adjusted?
Analysts ask several vetting questions on each line item from an income statement to determine whether adjustments should be made:
- Was the expense non-recurring, discretionary, non-market, or non-operating?
- If the business were sold, would the expense disappear under new ownership?
- Is the expense (e.g., rent) at the market rate? If not, in what direction and by how much should it be adjusted?
To illustrate, suppose an owner receives compensation of $1.5 million, but the buyer plans to insert a replacement CEO for $500,000, the market rate for the position. The analyst would remove the $1 million difference from Owner’s Compensation and increase income.
Adjustments are often found in line items like charitable contributions, rent, professional fees, auto, owners’ compensation, and non-operating expenses. However, any line item could contain amounts that satisfy the requirements for an adjustment.
Other questions owners and their financial advisors might ask to determine if normalizing adjustments should be made include:
- If the company were sold, would the buyer incur this expense? If it disappeared, it could be an add-back.
- If the expense were discontinued, would it adversely impact revenues or other benefit streams? If not, it could be an add-back.
- If owners believe historical expenses were excessive, would buyers right-size them after a sale? If yes, it could be an add-back.
- Was the line item ordinary or non-ordinary? If it is unusual and not likely to happen again, it could be an add-back.
- Was the expense at a market rate? If not, it could be an add-back.
- Were expenses or revenues unrelated to operations? If non-operational, they could be an add-back.
- Were the expenses discretionary? If so, they could be an add-back.
Let’s apply the questions to the simplified five-year income statement below to illustrate how normalizing works. The Unadjusted columns for each year reflect reported historical results. The Adj. column shows the adjusted amounts (a.k.a. add-backs). The reasons for the adjustments are in the narratives below. The Normalized column shows the adjusted income statements using the revised line-item amounts. The recasting exercise produces normalized income statements that reflect the true earnings power of the organization.
Let’s look at each line item to see how adjustments are made.
Revenues – Operating revenues are the money companies receive for goods and services. They are rarely adjusted because the IRS requires all revenues received to be recognized. However, in the so-called underground economy, some companies take cash from customers and never report it. Can owners add unreported cash to beef up revenues? Never! When taxpayers sign their returns, they attest to the IRS that the information supplied is accurate under penalties of perjury. Failure to report income is a crime. Those who take cash and don’t report it should guard their secret closely and not share it with potential buyers.
Tip: For those planning to sell in the next few years, start recognizing the cash so you can get value for it in a sale.
Cost of Goods Sold (COGS) – No adjustments were made to COGS in this illustration. However, some owners do bury questionable expenses in COGS that may still qualify as add-backs in COGS.
One owner I met built a house and recorded all the lumber as material purchases in his company’s COGS. While this would undoubtedly raise flags at the IRS, the valuation analyst’s objective is to identify the company’s actual earnings power and not to opine or help the IRS with its audits. In that instance, an adjustment was made as a non-recurring expense for excess compensation to the owner.
One might ask, “Isn’t padding COGS with personal expenses the same as not recognizing cash (i.e., a scheme to defraud the IRS)?” Maybe, but the expenses appeared on the income statement while the revenues did not. One can only adjust for what is there.
Sales, General, and Administrative (“SG&A”) Expenses
The income statement above shows a small sample of line items often found in SGA. Justifications for the adjustment include:
- Owner’s Compensation – In the early days of a company’s journey, revenues are hard to develop, and owners may receive no compensation. However, as businesses grow and prosper, owners sometimes recover from the years of sacrifice by paying themselves compensation exceeding industry standards. Excess compensation qualifies as an add-back if it is right-sized after selling. The adjusted amount is the difference between the actual compensation and the market rate (i.e., the industry standard for executives performing similar roles).
- Other Salaries and Wages – Owners frequently try to capture non-owner salaries and wages as excessive, but most buyers won’t allow it. Imagine the buyer’s speech to employees announcing the purchase: “We are the new buyers and extremely excited to build on your established foundations. We have ambitious aspirations that should lift everyone. However, we must first whack your salaries and incentives because the previous owners said you were overpaid.” No buyer wants to make that speech, so non-owner salaries and wages rarely change after closing.
- Charitable Contributions – The seller might have supported specific charities that buyers might not. Charitable giving is an example of discretionary expenses that always qualify as add-backs.
- Rent – Owners frequently create related entities to own and lease real estate to the operating company. The lease agreements may not be at arm’s length, and lease terms may not reflect market rates. For example, if the company rents a facility at $19 per sq. ft. from a related entity when the market rate is $12 per sq. ft., the tenant overpays rent by $7 per sq. ft. The excess rent must be added back because it reduces income. Alternatively, if the operating company gets a sweetheart deal and pays less than market rent, it must adjust rent upward by the discount. The assumption is that an arm’s length buyer would not get the same deal as related parties after closing, so rent must be adjusted to market either upward or downward.
- Professional Fees – These charges demonstrate the effect of non-ordinary, non-recurring expenses. The income statement above assumes that legal costs spiked in 2021 and 2022 due to a lawsuit unlikely to happen again. Because of their non-recurring nature, the buyer will not have these costs after closing. [2]
- Auto Expenses – Private companies often provide owners and sometimes their families with cars. Unless vehicles are necessary to conduct business (e.g., an electrician’s van), Auto Expenses are typically treated as an add-back. Most buyers would not absorb auto expenses that are not required for the job. Delivery, service, and other operating vehicle costs are ordinary business expenses and are not adjustable.
- Owner’s Insurance – Companies sometimes pay the cost of owners’ insurance. The expense should be removed if the premiums disappear after closing and the company is not the policy beneficiary.
- Travel – Travel is a necessary business expense for many companies. However, when spouses and children accompany owners to luxurious locations, extend stays, and pay for excursions, the personal portion must be added back.
Other Income/(Expenses) – When income statements are correctly configured, non-operating income and expenses appear below the operating income line. Non-operating income includes interest on savings and gains from selling old assets. This income is derived from sources other than the sales of products and services and would not be passed to the buyer. Similarly, non-operating expenses include interest on debt, asset sale losses, and other costs unrelated to business operations. A buyer would not assume a seller’s debt or other non-operating expenses. Therefore, Other Income/(Expenses) are excluded from the EBITDA calculation.
From this normalizing exercise, adjusted EBITDA was higher than unadjusted EBITDA for each year. The adjustments reveal the organization’s true economic earnings power.
Practical Tips When Normalizing
Here are some practical tips to help owners and their advisors avoid common pitfalls:
- Document Thoroughly – When selling, buyers will challenge every add-back, so maintain thorough documentation that justifies the amounts and logic for each adjustment.
- Avoid the Appearance of Greediness – An adage says, “Bears get some, and bulls get some, but pigs get slaughtered.” Don’t get too greedy by claiming questionable adjustments. Excessive add-backs are red flags for buyers and can erode their confidence in all the numbers.
- Be fair – If certain expenses are below market rates, adjust expenses upward to reflect what buyers will experience after closing.
Transactions are complex and challenging to complete. Sellers who accurately and fairly present normalized financial statements to buyers early in the process build good faith with buyers and increase their chances for a desirable outcome based on the company’s true economic earnings power.[3]
[1] Other financial benefit streams use more advanced formulas to measure earnings power and value. For instance, Free Cash Flows to Total Invested Capital incorporate income and balance sheet items to determine how much cash is available to support all the business obligations and deliver returns to investors. Analysts using the Discounted Cash Flow models forecast free cash flows and a future selling value. They then return the future benefit streams to present dollar values by applying risk-adjusted discount rates.
[2] Other non-recurring expenses might include the costs of preparing for a business sale like a valuation.
[3] Buyers and sellers must execute Confidentiality and Non-Disclosure Agreements before sharing confidential information.
William “Bill” Loftis is Managing Partner and co-founder of Blue River. Mr. Loftis developed a passion for M&A as a transaction principal, and has assisted buy and sell-side clients through the M&A process in multiple industries. He earned a B.A. in Business Administration from Alma College and a Master of Science in Finance from Colorado State University. Bill’s full bio is available here.
About Blue River
Blue River Financial Group is a middle market merger and acquisition advisory firm headquartered in Bloomfield Hills, Michigan. It assists corporations, private equity groups and individuals in the sale and acquisition of businesses, and has completed assignments in multiple business segments. With over 20 years of experience spanning across 50 global industries, Blue River provides a suite of services to middle market clients including corporate development, private equity support, valuations and transaction consulting, placing a premium on relationship-centered transaction counsel and client focus.