Suppose a business appraiser asked an owner, “How much profit is your company generating?”
The owner says, “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 the company to reduce earnings and taxes.”
Should the appraiser be A) Aghast at the owner’s mendacity for manipulating earnings to avoid paying income taxes. B) Sympathetic because the IRS gets too much already. C) Unsurprised because the IRS permits companies to write off non-recurring, discretionary perquisites and other nonoperating expenses, and there is no harm in recognizing allowable costs.
If you chose C, you answered correctly.
Unlike public companies, which report the highest earnings possible to drive stock prices up, private companies don’t share their financial statements with the public. Therefore, they generally report the lowest earnings possible to minimize taxes. They do so by incorporating IRS-allowed expenses that reduce taxable earnings.
But if owners purposely reduce earnings by inflating expenses, how can anyone know what private companies are worth? Internal Revenue Code 59-60 directs business 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 excessive, nonrecurring, discretionary, non-market and other nonoperating expenses. Let’s unpack that sentence.
true economic earnings power
Buyers of privately held companies invest capital hoping to generate returns from future cash flows generated from business operations during the holding period and appreciation when it’s sold in the future. EBITDA is a standard benefit stream used in the M&A 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.
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). But suppose the company had $2 million of nonrecurring expenses associated with relocating to a newly constructed facility. Without the nonrecurring expenses, EBITDA would have been $7 million, and the expected sale price would rise to $49 million ($7 million x 7), a $14 million uplift.
Adjusting income statements
Analysts ask several vetting questions on each line item to determine whether adjustments should be made: Was the line item excessive, nonrecurring, an unusual owner perk, discretionary, or nonoperating? If the business were sold, would the line-item change? If so, in what direction and by how much?
Other regular adjustments include charitable contributions, rent, professional fees, auto and nonoperating expenses. However, any line item could contain amounts that satisfy the adjustment requirements.
Practical Normalizing Advice
When selling, buyers will challenge every add-back. Therefore, maintain thorough documentation justifying the amounts and logic for each adjustment. Be careful not to get too greedy by claiming questionable adjustments. Excessive add-backs are red flags for buyers, causing them to lose confidence in all the numbers.
William Loftis is Managing Partner and co-founder of Blue River Financial Group.
