Normalizing Financial Statements

If you’re like most business owners, you’ve operated your company in a way designed to minimize taxes. You may have given yourself and your family members as many perks and benefits as possible, kept offspring on the payroll, and written off other expenses through your business – all of which contribute to decreased earnings, and, therefore, a lower value for your business. These and certain other common practices are designed to keep your profits and your taxes low, perhaps artificially so.

All well and good. But when the time comes to properly value your business, financial statements, which form the basis of all business valuations, must be “normalized” or “adjusted.” 

The normalization process involves making numerous adjustments to your financial statements so that the true earning capacity of your business can be identified.

Common adjustments include the following:

• Your salary and perks
• Family members’ salaries and perks
• Expenses or income that would not be expected to recur or continue after the sale
• Personal expenses, such as personal auto, insurance, cell phone, child care, medical, and travel expenses
• Depreciation
• Amortization
• Investment or other non-operating expenses or income
• Interest payments on any business loans
• Other one-time or non-recurring expenses
• Non-operating revenue

Removing owner-specific perks, benefits, and expenses is necessary to show potential buyers your business’s actual available cash flow.

Adjusting the financials allows you to compare your business with other businesses using seller’s discretionary earnings (SDE) or earnings before interest, tax, depreciation, and amortization (EBITDA).

• SDE: This is the most common metric used by buyers, business brokers, and many other professionals for valuing companies with annual revenue of less than $5 million.
• EBITDA: The most common metric used for valuing businesses with more than $5 million in annual revenue is EBITDA.

Adjusting your financial statements is one of the most important steps in preparing your business for sale.

Buyers compare potential acquisitions using SDE or EBITDA. By comparing the SDE or EBITDA of one company with another, buyers can easily understand a business’s value based on the business’s actual profit rather than its taxable income. This helps facilitate a more accurate comparison between companies.

Roll up your sleeves and get ready to dig in …

Definitions of Adjustments 

Here are descriptions of the different types of adjustments that can be made. 

• Discretionary Expenses: These are expenses paid for by the business that are a personal benefit to the owner. To qualify, the expense must personally benefit the owner, not the business or its employees. These expenses must be paid for by the business and be documented as an expense on the P&L statements. 
• Extraordinary Expenses: These refer to expenses the business paid for that are exceptional, unlikely to recur, and are documented as extraordinary. Examples include expenses associated with natural disasters, relocation of the business, or a lawsuit. Examples that don’t qualify include a marketing campaign that failed or headhunter fees to replace a manager who resigned.
• Non-Operating Revenue and Expenses: These are extraordinary expenses or revenue unrelated to the business operations, such as interest earned on investments, revenue from the sale of equipment that is no longer used in the business, or insurance settlements. Non-operating revenue should also be removed.
• Non-Recurring Revenue and Expenses: These are expenses that are unusual or one-time in nature and not expected to recur, such as a large legal bill, moving expenses, or a cleanup bill from a natural disaster. Examples of non-recurring revenue include revenue from the sale of a large asset or an insurance settlement.

If you are aggressive or inaccurate with one adjustment, most buyers will question the credibility of everything you say from that point on.

Sample Adjustments

Following are adjustments that generally are allowable and can be adjusted:

• Accounting: Any accounting fees that you have incurred that are unrelated to the business or which are for other businesses or personal matters.
• Amortization: All amortization.
• Barter Fees: Any barter-related fees and income. 
• Child Care: Payments for child care that do not relate to the business.
• Continuing Education: Any continuing education expenses that are not related to business operations.
• Cost of Goods: Expenses for anything purchased for personal use and which were not used for the business.
• Depreciation: All depreciation.
• Entertainment: All personal entertainment and related expenses.
• Insurance: Any insurance expenses related to personal needs, such as health insurance, auto insurance, dental insurance, and life insurance.
• Interest: All interest expenses, unless necessary in your industry, such as floor financing for auto dealerships.
• Legal: Any personal legal fees.
• Meals: Any personal meal expenses.
• Medical: Any personal medical expenses.
• Memberships: Any fees for personal memberships that do not relate to the business.
• One-Time Expenses: Any investments in new equipment, one-time start-up expenses, build-outs, major repairs, or one-time legal fees, for example.
• Owner’s Salary: Your W-2 or 1099 income, including your payroll taxes and any payroll taxes that have been paid by your company – but not your draws or distributions. Only salary in the form of W-2 or 1099 income can be added back. Note: this is added back when calculating SDE, but normalized to market rates when calculating EBITDA.
• Payroll (Other): Any payroll taxes for your salary and for the salaries of non-working family members.
• Personal Vehicle Use: Any automotive expenses, payments, fuel, insurance, and repairs for non-business purposes.
• Rent: If you own the property, adjustments should be made to normalize the rent to market rates.
• Repairs: Any repairs for your personal home or other personal property.
• Salary: Salaries paid to non-working family members. 
• Supplies: Personal supplies, groceries, etc.
• Taxes: Personal and corporate income taxes.
• Telephone: Personal cell phone-related expenses.
• Travel: All expenses related to personal or nonessential travel.

Adjustments that are generally not allowed or can’t be adjusted include:

• Rent: If you own the property, the rent amount should be based on the cost to rent the property, not the cost of ownership.
• Unpaid Family Members: Salaries for working family members should be adjusted based on the cost in the market. Salaries for non-working family members should be added back.
• Employees: Salaries for underpaid employees, such as family members working in the business, should be adjusted to market value.

Here is a list of adjustments that might be adjustable:

• Bad Debt: This is any bad debt that is considered excessive, based on your prior years. We can often normalize this, but you should not remove it completely. If you had bad debt in the past in your business, you are likely to have it again. This should be normalized based on your prior years by deducting an even amount each year or by spreading a large bad debt expense over several years.
• Charitable Contributions: Owners often make charitable contributions with the expectation of getting business in return. For example, an owner of a restaurant might sponsor a local sports team. Doing so generates publicity and exposure for the business; however, directly measuring the results is impossible. You can adjust any personal contributions made that are not related to the business or in which the business did not receive any exposure, such as a private donation to your church.
• Continuing Education: Some educational expenses are considered discretionary and should not be removed just because they were optional. These expenses should be removed only if they were personal in nature and were unrelated to the business.
• Dues and Subscriptions: Any personal fees, such as country club dues, that have no expectation of benefitting the business.
• Retirement: Your 401(k) and IRA contributions for yourself and any family members only. Do not remove any fees related to maintaining retirement plans that benefit your employees.
• Travel: These are any expenses related to personal or nonessential travel. Any nonessential or excessive business travel should be identified. However, some travel is necessary for business.

The following expenses should not be removed and can’t be adjusted. You can identify these as expenses that can be reduced or limited, but these expenses should not be adjusted:

• Advertising: Owners often attempt to remove fees related to advertising because they feel the advertising campaign did not bring in any business and was considered a wasted expense. However, developing successful advertising campaigns always involves risk. This is a business cost and can’t be removed just because the campaign was unsuccessful. A new owner must continue to advertise and market the business, and many campaigns are unsuccessful.
• Cash Income: Unreported cash income should be verified through other means. 
• Entertainment and Meals: Dining with clients is a critical way of building relationships. These expenses should not be removed just because they were optional.
• Membership: Membership fees in country clubs and other clubs that are optional should be identified.
• Rent: The rent should not be adjusted if you are paying what is considered an over-the-market rate for your lease, unless the lease could be renegotiated.
• Salary: Overpaid employees’ salaries should not be removed. This can, however, be identified as an expense that could be trimmed.

Tips for Making Adjustments

Be Thorough

It is important to remember that all adjustments should be concise and verifiable. The more thorough and accurate your documentation regarding your business expenses, the better. 

If you are aggressive or inaccurate with one adjustment, most buyers will question the credibility of everything you say from that point on. This is why I recommend you hire an objective third party to make these adjustments and calculate your SDE or EBITDA. 

The more detail you provide, and the more documentation to back up your reasoning for claiming your expenses, the more likely your business will sell quickly and for the best price possible.

Be Conservative

When selling a business, always be conservative when making adjustments to your financials. There are several reasons why this is important.

If you are conservative, the buyer will assume you have been conservative regarding other issues as well and the buyer may verify fewer of your representations during due diligence. On the other hand, if your adjustments are aggressive, the buyer may feel the need to perform more thorough and exacting due diligence.

Value is a function of risk. The lower the risk, the higher the value. 

A buyer who is dealing with a conservative seller will view the transaction as less risky and may be willing to pay a slightly higher multiple than if the buyer were dealing with an aggressive seller. 

Keep in mind that when I say “aggressive” in the context of selling a business, I am referring to the representations that are being made. 

An example of an aggressive representation is, “We can definitely grow revenue by 20% per year for the next five years.” 

An example of a conservative representation would be, “We have grown revenue by 18% to 22% during the previous three consecutive years, and we hope this trend will continue. However, we are always aware that the economic and competitive landscape can change at a moment’s notice, and our estimates are just that – estimates.”

If your behavior is excessively liberal, the buyer may include “representations and warranties” in the purchase agreement to protect themselves after the closing.

This could include language in which you warrant that any claims you made were true to the best of your knowledge. If your representations later prove to be untrue, your representations will come back to bite you, even after the closing. The buyer can sue you, or even offset losses from your representations against future payments via a setoff.

Let’s be clear on what representations and warranties are and why they are important. Also known as “reps and warranties,” these are statements of facts you make in the purchase agreement regarding your company’s business, assets, liabilities, and operations. Many sellers think they can run off into the sunset after closing, free of all future obligations related to the sale of their business once the check clears. Not true. The reps and warranties you sign in your purchase agreement survive the closing when you sell your business. 

In the purchase agreement, you indemnify the buyer, and a breach of a representation will be subject to indemnification. In other words, if a statement you make later proves to be untrue, the buyer may offset a portion of the purchase price, withhold funds from escrow, or sue you to make themselves whole again. For example, if you make erroneous adjustments to your financial statements and these adjustments later prove to be untrue or inaccurate, the buyer can seek damages from you, even after the closing. 

The bottom line is that you’ll remain liable for a significant period of time after the closing if any of your representations later prove to be untrue. I cover reps and warranties in greater detail in the chapter on Closing.

The fewer the adjustments when selling your business, the cleaner your financials will look. Step back and look at your P&L. How many total adjustments do you have? Don’t look at the total in dollars, for example, $436,950 in adjustments, but rather look at the total volume, as in, 14 adjustments in the most recent year – the fewer the adjustments, the better. 

When a buyer first looks at your P&L, the total number of adjustments is one of many factors they will take into consideration when evaluating your business as a potential acquisition. If your P&L is clean, with minimal adjustments, a buyer may assume that due diligence will be faster and less expensive. 

I recommend not including any adjustments less than $500. Your goal is to reduce the total number of individual adjustments, not the total amount of adjustments. Adjustments less than $500 do not impact cash flow enough to have a substantial impact on the valuation. A P&L statement with fewer adjustments looks “cleaner” to a buyer and may justify a higher valuation because the buyer may perceive that fewer adjustments must be verified during the due diligence period.

If you minimize adjustments, they will assume you will be easier to deal with than other business owners and are therefore running your business in an upright, above-board fashion. Collectively, these strategies build trust with the buyer, thereby reducing risk and thus maximizing value for you during your business sale. It may even lessen the burden of due diligence.

Value is a function of risk. The lower the risk, the higher the value.

The ideal scenario is to eliminate adjustments altogether at least two to three years prior to a sale. This will increase the value of your business and improve the buyer’s odds of obtaining financing for your business. Doing so may enable you to cash out at closing instead of taking back a portion of the proceeds in the form of a three-to seven-year promissory note. 

If you want to maximize the purchase price, there is one trick you can employ. Be conservative regarding your adjustments but be aggressive regarding the multiple you choose when valuing your business. When doing so, you must develop a strong position to justify a higher multiple. 

Here is an example:

Comparison of Conservative vs. Aggressive Adjustment Approaches
	Business A	Business B
Net Income	$1,000,000	$1,000,000
Adjustments	$500,000	$300,000
EBITDA(Net Income + Adjustments)	$1,500,000	$1,300,000
Multiple	3.0	3.5
Asking Price(EBITDA x Multiple)	$4,500,00	$4,550,000

You can often justify this higher multiple, as in Business B, if you can demonstrate to the buyer that your business is lower risk. Not only must your business be low-risk, but your disposition in all interactions must also be conservative and modest. But don’t overdo this. Demonstrate conservative optimism. Humility can backfire if it’s overdone.

The strategies above don’t prevent you from keeping “potential adjustments” in your back pocket to whip out as needed when selling your business. For example, if you pay $5,000 per year in country club dues but you occasionally network with a business friend at the country club, then you could consider keeping this adjustment in your back pocket. You can mention these adjustments later. Just don’t put them in writing and only mention them if necessary. 

If the buyer is performing due diligence and they uncover a few problem areas or attempt to renegotiate the purchase price, sit down, and have a talk. Walk the buyer through the expenses you decided not to adjust. Tell the buyer you wanted to be as conservative as possible and point out each expense that you believe should be adjusted but which you chose not to.

Yes, being conservative and humble pays sometimes.

How to Easily Produce a Detailed List of Adjustments

The best way to prepare a list of your adjustments is to export a detailed P&L, or “General Ledger,” from your accounting software to Microsoft Excel or another similar program. This is called a “P&L Detail” in QuickBooks. The detailed P&L lists every transaction for each account on your P&L statement.

Once you have exported this to Excel, simply mark each adjustment with an “X” or highlight the entire row. The advantage of doing this is that you will have a highly organized, detailed report available for buyers when they perform due diligence. 

Simply show the buyers this report and the buyer will be able to tie the adjustments to the specific entries in your accounting software. However, the buyer may request the source documents, such as receipts for the transactions, so be prepared to produce detailed invoices or receipts if the buyer requests them.

Many sellers think they can run off into the sunset after closing, free of all future obligations related to the sale of their business once the check clears. Not true.