2.12 Normalization adjustments in valuation reports
The definition of fair market value (which is the goal of most business valuation reports) implies that a valuation report should assume that the business will, at least notionally, change hands. This implies that the various ways by which the current owner has taken value out of the company should be re-set to amounts that assume that management and ownership are at arm’s length. It also implies that any historical non-recurring items should be eliminated. By making these adjustments, the pro forma cashflow statement will be both sustainable, and normalized.
Fair market value assumes that all corporate relationships are at arm’s length.
A non-exclusive list of common items that require normalization are:
- Remuneration: business owners can receive their remuneration in various forms. It could be a low salary plus a high dividend. It could be a salary that is significantly higher than would be paid to a 3rd party or a salary paid to a family member who doesn’t work (much) in the business. Normalizing salaries and benefits assumes that these items in the pro forma cashflow statement are at levels that would be paid to an unrelated party doing the same work;
- Rent – building separately owned by the same owner as the business: in the pro forma cashflow statement, rent may need to be reset to a commercial level;
- Rent – building owned by the same business: at MVI we usually book notional rent at a commercial level in the pro forma cashflow statement and add the fair market value of the building as a “redundant” asset. This relates to the fact that yields (or capitalization rates) normally required from a business are different from those required from real estate;
- Bad debts, repairs and maintenance, and gains/losses on disposal of capital assets are examples of items that, although they do not usually involve the owner, can vary a great deal from year to year. Some level of judgment by the CBV is required to project a “normal” level for such items;
- Any other transactions with related parties should be examined and, if necessary, normalized.
Be sure to discuss normalization adjustments with MVI during the valuation engagement.