Most privately held businesses require some normalization of operating expenses to enable buyer to understand the selling company’s true earning potential. Below is a simple guideline of the five most common normalizing adjustments. We typically advise clients to be cautious with the level of “owner’s perks”, and corresponding normalizing adjustments, they run through the business as most buyers prefer to see a higher net operating income amount.
- EBITDA – A basic and widely accepted normalizing adjustment for businesses that tends to serve as a proxy for cash flow. This measure adds expenses from the income statement including interest, corporate income taxes, and depreciation and amortization back into the value of net income to derive the firm’s cash flow. While this isn’t recognized by GAAP, it is accepted by the finance industry and won’t raise any concerns with your tax filings.
- Non-Recurring Expenses – These expenses (or benefits) incurred by a business that wouldn’t normally affect the businesses profitability long term. Adjustments to this category might include, but certainly aren’t limited to, insurance payouts, moving expenses, and losses from discontinuing operations. However, other typical non-recurring expenses like lawsuits that may not be questioned for financial reporting purposes, could be questioned by a potential acquirer if the business is in an industry that is known for frivolous lawsuits. In cases such as these, an acquirer may deem lawsuits a normal, and recurring, business expenses that needs to be accounted for in the financial statements and should not be normalized.
- Personal Expenses – Expenses like travel, meals, entertainment, personal insurance policies like key man, cell phones, discretionary bonuses, and more are lumped together in this category. The simple answer is that all of these expenses can be normalized. However, the more complex answer is that not all of these adjustments should necessarily be included as business expenses that require adjustments if they aren’t related to the business. Additionally, overdoing it with your “owner’s perks” could set off a few red flags with the IRS – someone you may not want to attract.
- Travel should only be billed to the business if it is related to the business. Recognizing that this doesn’t always take place, owners can typically adjust expenses associated with a spouse joining them on the trip or additional days spent in a location that aren’t related to the business, but are billed through the business. Another expense that may get lumped in with travel is auto leases. Generally speaking, auto leases are an acceptable normalizing adjustment for the owner that shouldn’t raise concerns.
- Meals are only add-backs when they are not related to normal business activities. Technically, if it isn’t related to the business, then it shouldn’t be billed to the business. That said, when meals are billed to the business that are not related to business activities, then they can be normalized. A more appropriate example might include meal expenses related to taking on investors or selling the business, which are non-recurring in nature and are not related to normal business operations.
- Entertainment can be vague, which makes it a popular area for owner perks. If, for example, you have season tickets to local area sports teams (i.e., MLB or NFL) that are expensed through the business, and only sometimes used for clients or employees, then the difference can be normalized. Once again, this may not align with best practices as it relates to tax filings.
- Personal insurance policies, cell phones, and other related perks are generally acceptable normalizing adjustments that shouldn’t be an issue. These are expenses that advisors and analysts consider expenses that would not be incurred if the individual wasn’t the owner, and will not be present following the sale of the business.
- Family Member Expenses – Similar to personal expenses, some owners place extra expenses into this category as a way of lowering their tax bill and increasing the benefit to them and their family members. For example, an owner may pay their children 20% more for the work they do than they would pay someone else to do the job, or that the child would receive from other companies for the same level of work. Considering expenses like these would go away following a sale – presumably the acquirer would only pay fair market wages – they are acceptable normalizing adjustments. Additionally, because the individual pays taxes like any other employee, there wouldn’t be a legitimate tax issue.
- Charitable Contributions – Donations to charities are great and in most instances they can be normalized. However, instances when they cannot be justifiably normalized do exist. For example, if a business works with healthcare operations like hospitals and physician groups, then it would be hard to justify normalizing a charitable contribution to golf tournament that is sponsored by a hospital or insurance company that is an existing or prospective client. The argument would be that this is more of a business development expense. Alternatively, donations made to a local boys and girls club or youth community center should be normalized since they are not related to the ongoing nature of the business.
We hope this brief explanation on normalizing adjustments provides some clarity on what is (and is not) generally accepted as a reasonable expense adjustment. If you have questions on normalizing adjustments or tax filings, you should consult with your accountant, valuation, or M&A advisor.