Normalization is a restatement of the historic financial performance of a business entity to eliminate extraneous discretionary transactions and non-recurring items. Essentially, it's an exercise to reflect true and accurate earnings had any unusual events not transpired, and had the business operated in the hands of an objective "third party" i.e. without the impact of related party transactions initiated at amounts other than fair market value.
This step is necessary regardless of how a value is arrived at, because one needs to understand the historical performance of the business without any extraneous revenue or expenses being incurred. This is particularly true, when adopting an earnings based approach to valuation whether it be a simple multiple of maintainable EBIT/EBITDA or a more sophisticated approach i.e. a discounted cash flow or capitalized cash flow analysis, a fair value for the business cannot be determined until earnings have been normalized.
From time to time we meet a business owner with the misconception that normalization is an exercise to make their business more marketable for sale by simply finding a way to improve the financial performance as reflected in past reported results. In reality the opposite may be true, in that all transactions must be recorded at fair market value, either positive or negative.
As you would expect, the process of normalization is not always black and white and most often involves a large element of professional judgment, particularly when a company operates in a cyclical industry, has experienced volatility in their recent history, has undergone strategic changes and/or is influenced by owners' bias.
As an example, and perhaps the most common normalizing item when dealing with an owner/operator business is the normalization required for owner's compensation. Regardless of the form (bonus, salary) of how a shareholder is compensated, the required adjustment should reflect what would be considered normal market rates for a non-shareholder manager, not the actual compensation paid. Establishing market rate compensation is not always as readily determinable as one might assume, particularly when the owner/operator undertakes multiple roles. More often than not, this adjustment has a positive impact on earnings as excessive salaries, or bonuses are used to reduce active business income and take advantage of more favourable tax treatment.
Conversely, the owner of a business that is experiencing cash flow problems or reduced profitability may decide not to take fair value compensation from the business in any given year. In those circumstances, a prudent buyer would incorporate a negative normalizing adjustment for a market rate salary for those duties carried out by the owner/operator.
An owner's personal influence over the business can also impact financial results in other ways. An owner may support a particular charitable organization and at their discretion donate amounts that a buyer would deal with differently. Discretionary expenses can be incurred for items such as travel, which may not be essential to the short-term success of the business; salaries can be paid to family members for income splitting purposes, etc.
In addition, an operating company paying rent to a related party for the use of its facilities will often require normalization. Typically rent levels are set to coincide with mortgage costs, realty taxes and other miscellaneous maintenance costs in an attempt to keep the holding company whole, this in turn will usually vary from market rates.
An argument can often be made that a particular bad debt was extraordinary, in the event a customer falls into bankruptcy and there is a substantial receivable that becomes uncollectable. Although one can see the case for an add back, often the answer is not so obvious and most always subject to negotiation. Clearly, any adjustments must be reasonable in light of the companies past experience with bad debts.
A one-time sale that is unlikely to be repeated in the future under the normal course of business could also be deemed extraordinary and eliminated from the financial results to better reflect sustainability of the operations.
Of equal importance in the process of normalization is a review of the balance sheet. Any asset which is not essential to the operation of the business ('redundant assets') must be identified. For example, excess cash, (beyond normal working capital), unused land, securities, personal artwork, etc. should be segregated and extracted from the business for sale purposes in the most tax efficient manner.
Regardless of whether a buyer considered normalizing adjustments when they first formulated their offer or not, a seller can be certain that all normalizing adjustments will be challenged and must be reasonable, and supportable, otherwise they could form the basis of a purchase price adjustment. The seller, or his or her agent can present their assumptions, build a case as to why stated normalizing adjustments are necessary and track all adjustments back to the audited or reviewed financial statements that conform to the Canadian accounting standards for private enterprise, all helping to ensure the seller realizes a fair value for their business.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.