Personal and one-time expenses can make getting a true picture of a company’s earnings history difficult, particularly in smaller family businesses. This presents challenges when marketing the business for sale, as the buyer and seller need an accurate representation of how the business has performed. Normalization adjustments are the solution.
“Normalizing a company’s historical earnings means adjusting them to eliminate personal or one-time expenses that are not essential to operating the business in normal course. Normalization allows the seller to show true operating earnings on a historical basis, without being penalized for showing nonessential expenses running through the business. This also allows the buyer to get a true picture of the operating earnings for purposes of determining value,” says Albert D. Melchiorre, president of MelCap Partners, LLC.
Smart Business spoke with Melchiorre about how this process impacts the merger and acquisition (M&A) process.
What are some common adjustments used in normalizing historical earnings?
The use of normalization adjustments, which are sometimes called addbacks, is often as much an art as it is a science. An experienced M&A adviser is essential for determining what are appropriate and supportable addbacks before the business goes on the market.
Some common normalization adjustments include: elimination of personal automobile or travel expenses, excess rent expense, excess or above-market salary or other compensation paid to the owner, as well as excessive or one-time professional fees.
In the case of normalizing excessive professional fees, the seller needs to consider if the services provided by professionals were absolutely essential for normal business operations.
What does the amount of adjustments say about the seller and his or her business?
Use of normalization adjustments ultimately has a direct impact on the value of the business, but it also sends a message to prospective buyers.
While a seller does not want to leave any value on the table by missing legitimate addbacks, it can be the case that being too aggressive in their use can cause a prospective buyer’s guard to go up. It is an important balancing act for the seller to try and be aggressive enough to legitimately maximize the company’s value while also maintaining credibility and building trust with the prospective buyer.
The M&A adviser should be able to uncover solid addbacks while vetting out those that are questionable or unsupportable before going to market.
Should I consider possible synergies with buyers when normalizing earnings?
Financial buyers, such as private equity groups, may or may not currently own a business that is similar to the seller’s business. To the extent there is a strategic fit, the seller may think about all the cost savings that can be realized by the buyer if the businesses are combined. In doing so, the seller may make assumptions about these anticipated cost savings and include them.
While these savings may be legitimate, sellers should realize that buyers are reluctant to pay for the synergies that they bring to the table. It’s also important to remember that each buyer is different, and in order to submit a uniform presentation of normalized earnings, these types of synergies should most often be excluded when marketing the business.
It is a good idea to discuss these types of synergies with your M&A adviser to get a sense of the flexibility that a strategic buyer might have during the bidding process, as well as how to convince the buyer to pay for some of the synergies this could potentially bring in order to successfully land the deal.
Albert D. Melchiorreis president of MelCap Partners, LLC. Reach him at (330) 239-1990 or [email protected].
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