In the May/June 2015 issues of Brueggeman & Johnson Yeanoplos’s Litigation & Valuation Report, there’s a short article on the valuation adjustments a business appraiser makes. They state an overriding objective is to “ask whether a company’s past earnings represent its future earnings potential to a hypothetical buyer.” If not, they have to adjust it to do so.
There are three adjustments pertinent to my day-to-day business of small and mid-sized business buy-sell and exit planning (ignoring adjustments for things like minority share discounts or swing-vote premiums).
- Expenses must be brought “in line with industry norms” (italics added). They state this typically is owner compensation and perks plus related-party transactions (business rents from the owner at a non-market rate or has an affiliate company sell them components at a reduced rate). Owner comp and perks is the big one. Note these (very accomplished) valuators say “bring in line with industry norms” not “add owner comp to profit.”* I like to say an appraiser will use “the fair market salary for the job of running company” for the expense line item for owner comp when doing a valuation.
- Singular events will be adjusted out or in. The costs of a once in 20-year lawsuit can be added back to profit. Of course, the once in a lifetime sale that spikes sales and profits by 37% in one year, and only one year, will be taken out.
- There will be “changes to excess or deficit working capital (compared with the company’s normal operating needs).” Simply put, a business comes with normal and adequate working capital. A working capital adjustor will protect the seller if, for example, the month prior to closing is huge, creating a surplus of working capital (the seller keeps the excess). It protects the buyer in case business is slow immediately prior to closing and discourages the seller from accelerating AR while not paying bills.
* As those of you who know me know, I think the term Seller’s Discretionary Earnings (or similar terms), used to inflate profits by including owner salary in profit is a bogus term, and borderline fraudulent. It’s definitely misleading, especially when it convinces a naïve buyer his or her salary is “discretionary.” Last I heard, mortgage payments, insurance, food, taxes, etc. were not discretionary.
“Put a thief among honest men and they will eventually relieve him of his watch.” Flann O’Brien