When performing a business valuation, it is not uncommon for the valuator to make normalization adjustments. These entries are intended to change certain financial data of a business to make the best possible estimate of the true economic earning power of the entity. Normalization adjustments often deal with items the owner or manager expends that are discretionary. These adjustments may also relate to unusual or infrequent transactions that are not typical to the business.
The amount and extent of adjustments are dependent on the purpose of value. For instance, if the block being valued is a minority block that cannot adjust management compensation… it stands to reason that we cannot make normalizing adjustments to comp.
Examples of normalizing adjustments
Owner Compensation. What would a non-shareholding manager earn to fill the operating role that an owner does?
Owner perquisites. Many owners enjoy various perks of ownership. For example, an owner might have season tickets to sporting events, or an expensive “company car.” To the extent that these expenses do not support the business, we would make a corresponding adjustment to remove them.
Extraordinary / unusual one time expenses. For example, the income (or expense) related to an insurance settlement might be adjusted as it is not likely to be reoccurring.
Related party transactions. For example, below market rent to an affiliated company would be adjusted to market rate.
The goal of the process of normalization is to provide a fair and reasonable look at the business’ expenses from a completely unbiased perspective. Once this is accomplished, the result of the business valuation will be of greater value to all the parties involved.